FALLS CHURCH, Va.–The SRI Portfolio continues to outperform.

New readers, please note that this is a long-only portfolio. I imposed this restriction in order to fairly compare performance against benchmarks, and all major market indexes are also long-only.

Though quarterly results aren’t my main concern, the end of the period offers an opportunity to assess performance since inception. I also publish yearly returns at the appropriate time.

Since its inception 15 February 2006 through the end of the first quarter of 2007, the Portfolio is up 29.6 percent, while our benchmark–the Morgan Stanley Capital International All Country World Index Total Return (MSCI World Index), which includes gross dividends—is up 19.8 percent. The S&P 500 is up 10.8 percent, including dividends, during the same time frame.



Source: Bloomberg, SRI

Two of the three permanent hedges–US Treasury bonds via the iShares Lehman 7-10 Year Treasury Fund, recommended in early March (see SRI, 8 March 2006, Hedge Your Bets), and gold bullion, recommended in late March (see SRI, 29 March 2006, Right You Are…)–also made respectable contributions. The former was up 6 percent, while the latter was up 15.2 percent.

I initiated the bond hedge at a time when many pundits were busily justifying their views as to why the 10-year US Treasury yield was about to rise to 6 percent and beyond in 2006, a target first revealed at the beginning of the year.

But bonds didn’t collapse, a fact that should have come as no surprise to SRI readers. Furthermore, bonds proved a good hedge instrument, holding their own during uncertainty this past year. Consequently, the 10-year yield is still in a downtrend, implying bond strength.



Source: Bloomberg

Given my long-held bullish view on gold, a word on the metal is warranted.

It’s becoming increasingly obvious that the majority of investors remain uncertain as to what will be the final outcome of the Federal Reserve’s moves and the slowdown of the US economy this year. The debate between deflationists and inflationists remains animated.

I anticipate an eventual deflationary outcome (i.e., a deleveraging of the consumer). Yet the only hedge able to cover both is gold.

Gold has been the object of ardor and the target of scorn throughout the centuries but has never been refused as means of payment. The reason is that gold has no substitutes.

And given the demand for gold we’ve seen during the past three years (from central bank buying to new gold exchanges and liberalization of trade around the world), gold has become the world’s fourth currency. In today’s world of massive deficit spending and financial imbalances, expect demand for gold to continue to increase.

I first recommended gold as a hedge three years ago (while overseeing a portfolio for another advisory), and the metal remains the ultimate bulwark. The metal is in a secular bull market that commenced in 1999 and should be expected to rise much higher, easily surpassing previous highs by the end of the decade. I strongly recommend gold as a hedge position for long-only portfolios.

The third permanent hedge position, shorting Consumer Discretionary SPDR, was recommended toward the end of 2006 and to date hasn’t made a visible contribution. This is a leveraged hedging short to a long-only Asia overweight portfolio and should be viewed as such.

Pay attention to the hedges and see them as what they are: protection for the rough patches. Protecting your portfolio is always a good idea.

India And China

The Reserve Bank of India (RBI) continues to take measures to cool down credit growth (running close to 30 percent) and consequent inflation (currently at 6.5 percent). Hence, the RBI increased the Cash Reserve Ratio (CRR) by 50 basis points to 6.5 percent, the third such hike in five months. Furthermore, the RBI also increased the repo rate (the rate at which the RBI lends to the market) to 7.75 percent.

It’s almost certain that the RBI will make its point and will achieve the results it’s looking for in the not-so-distant future. As a result, economic growth in India might slow from the currently elevated levels, but it will become more manageable (i.e., not so overheated) and therefore more sustainable. The RBI is practicing solid central banking, even if short-term growth slows down.

That said, the banks will be affected the most, as the tight liquidity situation will hurt margins. This is one of the reasons that at the current juncture I prefer pharmaceuticals over financials in India in the context of the Portfolio.

On another front, the US Dept of Commerce announced it will levy “anti-subsidy tariffs to coated free sheet paper imports” from China. This action once again brings to the forefront the politicization of the Sino-US relationship.

This is a symbolic action, as coated free sheet paper counts for less than 0.1 percent of China’s exports to the US. Nevertheless, it indicates that the US will try again to pressure China on the currency issue in an effort to force the Chinese to allow their currency to appreciate further.

It’s well known that a lot of politicians in the US, as well as big parts of their constituencies, believe that a faster Renminbi appreciation will help to decrease the trade deficit (currently USD232.5 billion) the US runs with China.

As a result, the threat of protectionism is once again looming. Although no real problems should be expected in the short term, longer-term risks may rise as the relationship between the two economies won’t materially change.

The US tried similar tactics (using trade restriction to force changes in exchange rates) in the 1970s and early ’80s. They didn’t work as well as expected, neither for the US nor the other economies. There’s no reason why this time things will be different.

But high rhetoric and technicalities aside, the main point is that the Sino-American relationship has become the most important one in the world, on the political as well as the economic front. The smoother the relationship, the better it is for everyone, especially investors. For more on China and the US, see SRI 22 March 2006, Until It Melts and 29 March 2006, Right You Are….

Portfolio Moves

My view on the markets hasn’t changed materially. I still think that portfolio risk should be managed carefully this year as the investing environment has become more volatile.

That said, given the negativity surrounding the markets, along with the fact that hedge funds have been shorting the S&P 500, the Nasdaq and the Russell 2000 like there’s no tomorrow, a short-term rally shouldn’t be ruled out. Although I’m not adding stocks this week, the portfolio is well positioned to benefit from a potential rally, while remaining defensive enough for the opposite outcome.

Investors who would like to add to positions in Portfolio recommendations should focus on the following markets, in order (for both countries and sectors): South Korea, Malaysia, Russia (telecom, energy), Singapore (telecom, banking, industrial), Europe (pharmaceuticals, oil, Industrials, communications equipment, media), Hong Kong, Japan (industrials, banking), India (pharmaceutical, banking), China (consumer, power), Taiwan (Telecommunications, Technology) and Macau.