A Sucker’s Rally?

Editor’s Note: The Global Investment Strategist is delivered to subscribers four times a month each Wednesday. On months with five Wednesdays, the Global Investment Strategist takes a one-week production break. The next issue of the Global Investment Strategist will be published on Wednesday, Feb. 22, 2012.

Asia has been at the forefront of the global stock market rally, with the MSCI Asia ex-Japan index up around 15 percent since the beginning of the year. Given the strength of the rally and the inflow of funds pouring into Asia, a number of investors have been wondering if it’s time to sell into strength.

We have made several recommendations recently to take partial profits on those Model Portfolio stocks that have produced extraordinary gains. We also know some investors who bet heavily on depressed, high-beta equities and liquidated their portfolios following the market’s gains last month.

Nevertheless, we believe the rally has additional upside. Investors are understandably concerned about Asia’s substantial inflows year to date. Since the beginning of the year, overseas investors have allocated roughly USD14 billion to Asia (excluding China), which is a little less than the total amount of last year’s USD16 billion in outflows.

Although these are strong inflows, they represent a mere fraction of the total market capitalization of Asian equities. Consequently, even if we view this as a “technical” rally, the flow of money into Asia has not yet reached an alarming threshold. Of course, a potential pullback could occur at any time, but Asian stocks should continue their outperformance unless there’s a shock to the global economy.

We’ve made the structural case for our bullish view on Asia numerous times in the past, so we won’t reiterate those arguments today. But as we observed in early December, an improving US economy could fuel the markets later this year. (See “The US and Asia will Lead the Way in 2012.”)

Ten weeks ago we noted that:

“The US economy has once again defied the perma-bears by avoiding a recession in 2011, as we predicted in October 2010. We also believe that there will be no US recession in 2012.

US gross domestic product (GDP) should grow by more than 2 percent next year because the country’s fiscal and monetary authorities and the political establishment will do anything in their power to stave off a recession during a presidential election year. It’s true that the US economy still faces structural problems that will have to be addressed sooner or later. But with the EU economy in dire straits, don’t expect drastic action from the US anytime soon.”

Since then, nothing has happened to alter that projection. In fact, more positive signs of economic growth have emerged. First, there is stronger than expected real disposable income growth in the US. And the housing market has stabilized and is even showing signs of life in some regions. While these numbers are hardly setting records, they are a welcome improvement from the US economy’s previous malaise.

From the stock market’s perspective, US corporations remain flush with cash, while their leverage ratios are at 20-year lows. They’ve even started borrowing again from banks.

As such, the market should produce solid gains this year. While overall market sentiment remains subdued, opportunistic investors should buy stocks trading at attractive valuations in markets that have lagged their peers, such as Taiwan.

In the short term, Taiwan should catch up with the rest of the Asian markets later this quarter once its elections have produced a pro-market outcome. (See “Taiwan: Welcome to the Status Quo.”)

Furthermore, the Taiwanese market tends to perform best in the first quarter of the year. And after its dismal performance in 2011, cash on the sidelines remains high and that should provide additional fuel for the market’s eventual ascent.

Source: Bloomberg

Still, investors should be cautious in approaching Taiwanese stocks. Taiwan is technically in the midst of a recession after having recorded consecutive declines in gross domestic product (GDP) during the last two quarters of 2011. And exports and industrial production have declined for three straight quarters, while domestic demand has collapsed.

However, we believe that this quarter should prove a turning point for the Taiwanese economy. Global economic indicators have started to stabilize, and demand is no longer declining precipitously. That bodes well for Taiwan’s predominantly export-oriented economy.

As external demand deteriorated last year, Taiwanese companies drew down their inventories, but they may finally be on the verge of restocking. For now, economic growth in the rest of the world should provide support for Taiwan’s turnaround. For example, the US Institute of Supply Management’s (ISM) index of manufacturing has risen to 54.1, and China’s Purchasing Managers Index is once again above 50. For both indicators, readings above 50 indicate expansion.

 

Source: Bloomberg

We continue to favor Taiwan’s technology sector because it remains relatively undervalued and offers the best growth prospects. In that regard, Long-Term Holdings Portfolio member Taiwan Semiconductor (NYSE: TSM) yields 3.6 percent and is a solid long-term play that deserves a place in a well-diversified portfolio.

As we noted last week, the company has been ramping up production of its line of high-performance 28 nanometer (nm) chips, and it now anticipates that this product line will account for 10 percent of sales by the second half of this year. (See “Tech Turnaround.”) That’s a testament to the company’s technological prowess, as well as to the strong growth in its telecommunications segment, which was responsible for 53 percent of its sales last quarter.

The company’s orders remain solid and it should start showing revenue growth by the second quarter. The stock has gained 112 percent since our initial recommendation in early 2009, but we believe shares should head even higher. Buy Taiwan Semiconductor Manufacturing up to 15.

Stock Talk

Add New Comments

You must be logged in to post to Stock Talk OR create an account