By Yiannis G. Mostrous

ATHENS, Greece–The SRI Portfolio continues to outperform and has managed to hold its own during the recent selloff, a particularly positive development as the Portfolio is long-only. I imposed this restriction in order to fairly compare performance against benchmarks, and all major market indexes are also long-only.

Quarterly results aren’t my main concern because the SRI investing horizon is long-term, but the end of the quarter offers the opportunity to assess performance since inception. I also plan to publish yearly returns at the appropriate time.

Since inception through the end of the second quarter, the SRI Portfolio is up 4.3 percent, while our benchmark–the Morgan Stanley Capital International All Country World Index Total Return, which includes gross dividends–is up 2.8 percent. The S&P 500 is down 1 percent, including dividends, during the same time frame.


Source: Bloomberg LP,SRI

In early March, I recommended that you start building positions in government bonds (see SRI, 8 March 2006, Hedge Your Bets):

This is the time to take a position in bonds. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF). Even if there is short-term risk, now is the time to gain exposure to the Treasury market.

Treat this as a more permanent hedge for the Portfolio because, later in the year, this hedge will become important to achieve positive returns. As previously explained (see SRI, 15 February 2006, The Rules Of Engagement), hedges will be monitored separately since the Portfolio is a long-only portfolio. Buy IEF.

The fund is flat since this recommendation, but my views remain the same. Continue to buy iShares Lehman 7-10 Year Treasury Bond Fund.

I introduced another permanent Portfolio hedge at the end of March (see SRI, 29 March 2006, Right You Are (If You Think You Are)), noting:

[I]t’s becoming increasingly obvious that the majority of investors aren’t certain as to what will be the final outcome of the Fed’s moves and the probable 2007 slowdown of the US economy. The debate between deflationists and inflationists remains animated.

I anticipate a deflationary outcome (i.e., a deleveraging of the consumer), and 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.

Consequently, I initiated a gold position as a permanent hedge. “Buy gold bullion; if storage is a problem, the streetTRACKS Gold Trust (NYSE: GLD) is a suitable substitute.”

Nothing’s changed to alter this view, and the recommendation still stands. The position is up 9 percent since March 29.

Speaking of gold, one argument (with which I agree) calls for an increase in the percentage of gold bullion in Asian central banks’ foreign reserve holdings.

A cursory look in the chart below shows that the governments of developed economies see the prudence of holding large gold reserves. The smaller players haven’t followed this trend. Eventually a shift will take place as developing economies begin to feel more secure and more able to decrease the levels of paper currency they currently hold. As the chart indicates, though developing economies’ positions are relatively small, even an incremental move on their part would be enough to positively affect the price of gold.

An additional interesting development for the gold market: India’s second-largest money manager plans to sell securities–in the form of an exchange traded fund (ETF)–backed by gold.

India consumes more gold than the US and China combined, and it’s estimated that Indian households have 15,000 tons of gold worth USD200 billion locked away in family vaults.

Although it remains to be seen if Indians will allocate some of their funds to the gold-backed ETF, the point is that we’re still in the early stages of gold’s reemergence as a legitimate asset allocation alternative, especially as a hedge against the paper standard that thoughtless US policymakers have been abusing and undermining.


Source: World Gold Council

Turning to the US, a recent Bloomberg/Los Angeles Times poll showed that the “American public has turned against the Federal Reserve’s two-year campaign of interest-rate increases, concerned it may hurt the economy by slowing growth.”

That sentiment should come as no surprise, as the preferred ways for increasing wealth–namely borrowing and real estate–might not fare very well as the Fed continues to drain liquidity.

It’s immaterial at this point whether the Fed stops or not. The long-term consequence is becoming not only more visible, but also more worrisome. The great American economic machine is hooked on cheap money and, consequently, an asset-based virtual wealth effect. At the same time, the threshold for economic pain is moving lower and lower.

From a global perspective, the main problem with this picture is that the world’s leading economy–a big contributor to Asia’s good fortune–is preparing to land, hopefully softly.

Serious investors should contemplate the probability that the US economy will prove unable to handle the shock, lose steam and trigger a recessionary 2007. In that case, expect Japan and the EU to outperform, on an economic basis, the US next year.

The second reason a US economic slowdown is important has to do with commodities. A slowing US economy will have a negative effect on commodity prices and the equity markets.

I’ve noted on numerous occasions that commodities hold the key to the market’s future performance (see SRI, 8 March 2006, Hedge Your Bets). A US economic slowdown can affect the market because it’s still an important direct consumer of commodities.

Common wisdom holds that China is the be-all, end-all for commodities. Although I don’t dispute China’s dominance (quite the contrary), the US’ importance has been understated. As the chart below illustrates, the US is still a major player in the commodities consumption game; it would be a mistake to assume that a slowdown won’t affect the commodities bull market.


Source: Morgan Stanley, HSBC

A potential Chinese slowdown on top of a US pause could put the break to the raging commodities bull market. The hope is that the market realizes this before it’s too late; this could be the difference between a serious, orderly correction and a stampede that destroys the long-term fundamentals of the current commodities bull market.

Based on this set of circumstances, on May 15, I reinitiated two short positions in BHP Billiton (NYSE: BHP) and iShares MSCI Brazil ETF (NYSE: EWZ). They’ve both worked out, and investors who followed the recommended stop losses should now be out of the trades with profits of about 6.6 percent and 11 percent, respectively.

Looking ahead, I’ll be seeking exposure to a few markets for the rest of 2006.

Japan remains a favored economy and market for the rest of 2006 and looks good for 2007, although it’s still rather early to make an assessment for next year.

India is another 2006 target and is also a long-term favorite (see SRI, 21 June 2006, Long-Term Bets).

The fact of the matter is that India has become the main beta market in Asia, with many markets trading off it. This isn’t necessarily a bad thing, though it creates short-term problems, especially during weak market periods. But the long-term arguments I’ve made are still valid; India is the ultimate growth story of our time.

Singapore is a good defensive market. Although it hasn’t performed as well this time around, fundamentals and economic planning seem to be pointing in a positive direction.

I continue to look favourably upon Thailand, and a solution to its political issues could help economy and market take off. Hong Kong should also be a long-term winner given the fact that it’s the main provider of services to China.

Regarding Europe, I’ll provide extensive analysis in an upcoming issue of SRI. I’m currently visiting the continent for an extended period, taking advantage of an opportunity to take a closer look at the secrets of this enigmatic economy.

Finally, expect the dollar to continue its structural decline for the remainder of 2006 through 2007. This will positively affect foreign investments of US-based investors; I’ll provide assessments for particular currencies in the near future.

An aside on North Korea: It started playing with its missiles again, reminding us that the world has a lot more problems to solve than people want to believe. Although North Korea is a problem, it’s more of a Korean peninsula problem than anything else.

This isn’t noted to diminish the threat of a desperate regime, but rather to put it into some perspective. The view here remains that North Korea won’t do anything foolish because the Chinese won’t let them. And Kim Jong Il is neither as stupid nor as incompetent as is portrayed by eager commentators in the media.

A Note To Readers

With this being a new service, I’ve received many questions about portfolio construction and stock selection. Let me take an opportunity to reiterate an explanation from prior issues:

The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while I also offer hedging ideas for more complete advice.

A characteristic common to the Portfolio companies is suitability for the new realities of a changing world. They’ll benefit the most from the changes taking place in the global economy.

No one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game is by not losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.

It’s important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories might offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.

Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done more easily this way. There’s always another week, and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.