Falls Church, Va.–The world’s markets are still in bull mode, with the majority of investors trying to capture this new leg up. As a Hong Kong-based investor told me over the weekend during a phone conversation, “It feels like the correction never took place.”

The reference was in regard to the 9 percent one-day drop in the Chinese stock market on February 27–the largest selloff in 10 years.

Nevertheless, 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.


Source: Bloomberg

Undoubted, the market can run a little further, but more time is needed for it to consolidate and move decisively higher. For the time being, my view remains the same (see SRI, 27 December 2006, SRI, Abridged II):

…investors will be able to enjoy good returns in 2007. The key is being correctly positioned and understanding that “good performance” isn’t defined by a straight line higher. Be prepared for volatility.

Volatility doesn’t mean bear market, and that can be a welcome, healthy change. What it means, though, is that if it sticks there will be different kinds of investment styles that will perform better going forward. These include large cap companies, high-quality investments and those more defensive in nature.

Despite the positives, the fact remains regarding the market’s future that investors have many questions that they’d like to answer but are for the time being unable to do so–at least in a definitive, reassuring way.

These unknown answers remain elusive for the simple reason that the global economy and the financial system are at turning points with a lot of uncertainty surrounding the main issues.

For starters, the US economy is poised for a slowdown that some commentators think can lead to a recession, which isn’t the base case here. (See SRI, 14 March 2007, Stay Cool). But the reason that no one is certain of the outcome of this slowdown is that no one knows what’s actually going on, especially quantitatively.

Everyone knows that the housing sector in the US is rapidly weakening and, most important, that the lending practices during the past four years have created some kind of credit bubble waiting to be deflated. But because of the endless financial engineering that’s taken place (through the securitization of loans, etc.), no one knows who holds what, what’s the real credit rating in these instruments (where different kind of loans have been packaged and repackaged into collateralized debt obligations, etc.) and what’s the actual size of the various markets involved in the securitization scheme.

Consequently, the assumption being made by the majority of market participants is that the risk has been spread around and, therefore, any potential adjustment won’t be as painful as before. But given the lack of real knowledge regarding the situation, this remains more or less a speculation, no matter how truthful it may be.

The Japanese carry trade has also been a worrisome development for the market. Although it’s undoubtedly a serious potential problem for investors, no one has really been able to accurately quantify it. Therefore, assorted talking heads are “inventing” the numbers and their significance.

The speculative situation in China—as mentioned above—also belongs to the great unknowns. Although we have anecdotal evidence, we’re in no position to quantify them and, therefore, to position our investments accordingly.

Geopolitics, long a big question mark in my book that a lot of investors still try to ignore, remain a great unknown as developments around the world indicate a much-bleaker outlook than many people allowed themselves to think possible not long ago.

As these unknowns perpetuate uncertainty, investors will remain trigger-happy and ready to sell at a moment’s notice. For the time being, though, global markets are trying to recapture the February highs, as the chart of the MSCI global index indicates below.


Source: Bloomberg

At this point in the game, the best strategy seems to be a less-aggressive one (on the long as well as the short side). Patience should prove helpful as you wait for a more-aggressive buying opportunity.

At the same time, though, having a well-diversified portfolio to strategically benefit from the investing themes in SRI is also important.

Portfolio Moves

Allianz AG will be removed from the Alternative Holdings Portfolio this week. The stock is up almost 36 percent since its recommendation, and now is the right time to book these profits. Sell Allianz.

The strategy going forward calls for investing in companies that offer relative earning certainty just like the majority of SRI’s Portfolio holdings. Gradually, more recommendations will be offered as we enter the second quarter.

As noted before, the working assumption is that long-term readers have taken profits off the table. That said, new Portfolio positions should be built based on the current SRI Portfolio recommendations.

Finally, investors who would like to add to positions in Portfolio recommendations should focus on the following markets, in order (for both countries and sectors): Korea, Malaysia, Russia (telecom, energy), Singapore (telecom, banking, industrial), Europe (pharmaceutical, media), Hong Kong, Japan (industrial, banking), India (pharmaceutical, banking), China (consumer, power), Taiwan and Macau.