…the Chinese market is vulnerable to a new decline in the not-so-distant future. The drop could be as big as 20 percent, and markets around the world would take notice again. Although the trigger could be almost anything (there was no real news that led to the previous selloff), the main reason is this market’s extremely high valuations.

Based on reliable information, retail investors in China have been eager to play the market. Although this isn’t a bad indicator on its own, the problem is that there’s early evidence that money is flowing through mortgages and credit card loans into the stock market.

The Chinese are known to be great momentum players, but practices of that sort have proved harmful before and will be again this time around. The timing, of course, is another issue.

Obviously, the Chinese market had a different idea, instead gaining 18 percent while also finding the time to correct a meager 5 percent in the process. Information straight from my friends in the region indicates that Chinese retail investors continue to buy small cap, low-quality stocks while avoiding mutual funds and the like. Consequently, the daily trading value has been growing between 15 percent to 30 percent per week.

The SRI Portfolios are well placed to benefit from the action in China. At the same time, the China-related recommendations in the Portfolios should be viewed as longer-term plays, with some occasional profit-taking advice.

As an aside, of the Chinese stocks in the Portfolio, the most illiquid (in regard to the shares trading in the US) is Hengan International. This is one of the reasons I recommended booking some profits recently. (See SRI, 11 April 2007, Tempering Greed.) The company is a long-term play, though, and should be purchased by new readers interested in the Chinese domestic demand story.

Recently, China’s weekly newspaper, the Economic Observer, reported that policymakers and market regulators had met in the last few days to work out fresh tightening measures in response to recent, strong economic data. Furthermore, the paper reported a possible capital gain tax could be introduced to cool the Chinese equity market. This could happen as early as this weekend because the government prefers to introduce such measures on Fridays.

From a narrow stock market perspective, the latter is of more interest. First, readers need to understand that tightening measures aimed at cooling down the economy don’t really affect the stock market’s performance.

Remember that in January–the last time the government wanted to slow down the market–it introduced stock market-specific policies such as a freeze on mutual fund inflows, strong pressure to brokers to slow retail demand, investigation of banks and brokers regarding their leverage practices and more. The government also discussed capital gains taxes, as it seems to be again, according to the above-mentioned publication.

Consequently, expect similar measures to be used in the event that a market slowdown is desired, as these measures worked in the past and will work again. If the measures fail and the market continues to charge ahead, investors should expect more volatility because an even greater amount of pressure will be needed to achieve the desired results.

I believe the government will be successful and the market will correct substantially. But as long as liquidity remains strong and earnings momentum continues to be positive, expect the Chinese market to turnaround and once again go higher. The end of all this is well known, but it’s not here yet.

Global Markets

As I’ve noted repeatedly, the global market looks strong. It will take a major exogenous shock or an outright US-led global recession for it to experience a negative year in 2007. Although 2007 may prove to be a bad year, as things stand now, I’m expecting the opposite.

It’s well known that bears, especially the perma kind, always sound intellectually superior to the rest. In danger of being viewed too pedestrian, I’d like to point out that the global stock market has doubled since its 2003 low while many investors kept the majority of their funds on the sidelines. This is why the market has risen steadily in the past four years but not spectacularly, i.e. climbing the proverbial wall of worry.

This could continue as long as the economic background remains fairly mundane; a recession can be quite hampering, as mentioned above. Don’t forget that the US economy has been slowing down for a year now while the rest of the world has done quite well, helping US GDP growth in the process. (See SRI, 21 March 2007, Made In America.)

Also recognize that the probability for a recession in the US has increased. However, my view regarding the economy remains the same as it was in December. (See SRI, 27 December 2006, SRI, Abridged II.)

The bottom line: Global markets could be substantially higher by the end of the year, volatility and corrections notwithstanding. Because of the latter, I recommend agility and patience because overexcitement can lead to disastrous results, both on the long as well as the short side.

Thailand

The SRI Portfolios continue to have zero exposure to Thailand, and a lot of readers have asked for my reasoning. The short answer: The country has become a policy minefield. It’s run by seemingly confused individuals who amply demonstrate that their main qualifications to govern have always been their willingness to work against the reforms of former Prime Minister Thaksin Shinawatra and their ability to carry out the wishes of Bangkok’s chattering classes.

The fact remains that a popularly elected prime minister was sacked for reasons that no one’s really been able to explain. As a result, all the policy gaffes that the new government is making–with more expected to come–will be magnified.

Thailand is in need of investment capital as well as measures designed to encourage domestic demand. The interim government seems to be working against both these ideas. At the same time, the Bank of Thailand may be behind the curve in regard to cutting interest rates and is, therefore, potentially hurting economic growth.

The main problem–as mentioned above–is that the Thai government has an anti-Shinawatra neurosis. Its officials seem to be in a race to distance themselves from policies and projects implemented by the old government. It’s becoming clearer by the day that budget spending will be less expansionary than before; the new government’s reviewers will have no problem canceling projects of the old regime while avoiding new programs of its own design.

The new government has also indicated it’s in a hurry to administer legal reforms, therefore increasing uncertainty among investors, especially foreign ones.

The government continues to introduce restrictions on foreign investment that make it very difficult for many foreign investors to obey the law. Consequently, there’s some anecdotal evidence that a lot of foreign companies are considering moving their operations out of Thailand to other countries in the region while new investments are increasingly difficult to come by.

As an example, the Japanese Chamber of Commerce recently informed the Thai government that a large number of Japanese companies will postpone their plans until next year. Given that Japan is Thailand’s largest source of foreign investment (36 percent of total foreign direct investment in 2006), you can understand that Thailand isn’t the best place for businesses in Asia right now.

The result of all this is that the domestic economy is losing momentum while the country is gradually destroying its chances for economic competitiveness, especially given the regional competition.

Consequently, the Thai market is the cheapest in the region. I think it’s cheap for a reason and could remain so for sometime. But if there’s any indication that something positive is taking place in Thailand, the market could skyrocket overnight.

Speculators–if willing to undertake some homework–could purchase shares on the cheap and the rewards could be huge. But from a portfolio construction perspective, I continue to avoid exposure to Thailand.

Fresh Money Buys

If you’d like to add to your positions in Portfolio recommendations or allocate new funds, focus on the following markets, in order (for both countries and sectors): South Korea, Malaysia, Russia (telecommunications, energy), Singapore (telecommunications, banking, industrial), Europe (pharmaceuticals, oil, industrials, communications equipment, media), Hong Kong (real estate, publishing), Japan (industrials, banking), India (pharmaceutical, banking), China (consumer, power, oil), Taiwan (telecommunications, technology) and Macau.

SRI Mechanics

I often include some notes regarding how I view the investment process. Long-term readers who have a grasp on how we do things can take a break, but those who are unclear on such issues should read on.

The SRI Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent. The areas I’m looking at for investment ideas continue to be mainly property, infrastructure, financials, retail, telecom and utilities.

I’ve noted repeatedly that the Portfolio should be viewed as a whole rather than an assortment of stocks. It’s my hard-earned assumption that investors seldom follow such advice, so I also offer some direction in an effort to assist with the decision-making process, under the Fresh Money Buys section.

That said, Portfolio recommendations should be taken at face value, in the sense that, if a stock is recommended as a buy and trades below the price indicated in the Portfolio tables, then the recommendation stands for new readers as well as longer-term ones.

Occasionally, I recommend–as I did in the beginning of 2007–that long-term readers take profits off the table. In December, I wrote:

I also advise long-term readers to take profits from ICICI Bank and Dr. Reddy’s Laboratories–without selling the stocks outright. Take any gains you have and leave the initial capital invested.

I’d like to make a couple clarifications. Regarding the mechanics of the above advise, I expect investors to look at their profits (i.e., how much money they’ve made above the initial investment) and then calculate how many shares they need to sell in order to take these profits off the table.

Second, if you’re not a “long-term reader,” chances are you probably don’t have profits to take from the specific stock; you’re unaffected by the recommendation. The fact that I haven’t advised selling the stock outright indicates that it remains a good, long-term holding.

SRI has one main portfolio, the Long-Term Holdings, and an alternative, the Alternative Holdings-Permanent Hedges. Investors should look first to the Long-Term Holdings for asset allocation in the markets covered here.

In the Alternative Holdings-Permanent Hedges Portfolio, readers can track permanent hedges and shorter-term recommendations. It also includes companies I’ve recommended for longer-term or more fundamental reasons, and they represent additional exposure to favored investment themes. For example, Lukoil provides extra exposure to a favored theme–Russia and energy.

On the left-hand side of the Web site’s main page, under the title Portfolio Performance, readers can get a snapshot of the Portfolio’s return compared to other major indexes.

On the Portfolio page, you can click on the asterisk next to each holding to review the original commentary and recommendation. I plan to enhance the Portfolio table with extra features and welcome comments and suggestions.

Finally, many new readers have asked, “What do we do when the market drops substantially?”

Since SRI’s inception, I’ve been skillful and lucky to either have booked profits before the fall, in which case I recommend sitting still, or issue a flash alert to sell if a substantial selloff is indicated, as was the case a year ago. (See SRI, 15 May 2006, Silk Road Investor-Flash.)