By Yiannis G. Mostrous

FALLS CHURCH, Va.–As things stand, world stock markets can stay stronger for longer, even after four rewarding years. Equity valuations remain at fair levels (although not as cheap as they were) and earnings continue to be strong. The global economy doesn’t look bad yet, but it is decelerating.

All indicators point toward a US-led global slowdown; the debate concerns whether the US will slide into a recession that leads to disaster for the rest of the world.

My view continues to be a little more sanguine. A brief look at some of the main junctures of 2006 is warranted, as it can help in evaluating 2007. I’ll present my forecasts for particular regions–e.g., Asia, Russia, Western Europe, Japan, etc.–in the weeks ahead.

I started the year quite bullish. SRI debuted 15 February 2006, during a time when sentiment was a little cautious because the global markets were already up 3.5 percent in US dollar (USD) terms.

In the second SRI, I wrote (see SRI, 22 February 2006, Still Looking Good):

Given my fairly bullish view, many questions have been asked regarding a potential correction in the global markets. A correction could come at any time, especially given the strong market performance during the past couple years. A potential correction, although painful in the short term, will prove healthy longer term, as genuine bull markets (e.g., Japan, Russia and India) will take a necessary breather before proceeding higher.

At the same time, expect 2006 to be a year investors will pay more for companies that invest in growth, especially given the healthy balance sheets corporations currently enjoy. Hence, a balanced portfolio that includes dividend and growths plays is–as always–the paramount need.

Right around that time the Economic Cycle Research Institute (ECRI) introduced its weekly leading indicator for the US, which leads GDP by two quarters. I noted that although the indicator caused some concern last year, it has since rebounded smartly and looks healthy. The indicator now looks like it’s bottomed and is now recovering nicely. See the chart below.


Source: Bloomberg

In May, my analysis indicated the selloff would be quite serious because growth and market leading indicators were deteriorating. I sent a Flash Alert that, with a little work beforehand and some luck thereafter, proved useful and timely. (See SRI, 15 May 2006, Silk Road Investor-Flash.)

Analyzing the selloff nine days later, I noted (see SRI, 24 May 2006, Risky Business):

There are two ways to interpret this chart. The bearish view is that this is the beginning of a period of prolonged market weakness. The bullish assessment is this was a liquidity-driven selloff that, while damaging, shouldn’t scar the markets. Perma-bears argue, of course, that they’ve been waiting for the selloff all along; such opinions warrant no comment.

The view here is that this is primarily a profit-taking selloff. Although it’s not necessarily over, it’s followed previous similar incidents of preceding years, at least in Asia.

Market indicators have begun to weaken again, but I’m not convinced yet that we’re in for a nasty surprise.

By July, I was getting bullish again. In August, I wrote (see SRI, 23 August 2006, Fall Rally?):

Looking at the markets right now, a rally can’t be ruled out for the simple reason that many market participants are still overly pessimistic–the conclusions drawn above notwithstanding. This pessimism is grounded in the expectation that the robust earnings growth enjoyed by companies around the world can’t last and that numbers should be coming down in the near future.

I have no argument with this notion per se. However, given the strength of earnings reported in the current season, I’d be very surprised if the numbers fall off the cliff.

Since then, global markets are up 10 percent in USD terms (a 37 percent annualized return).

There are, of course, risks, primarily those of a recession in the US, higher inflation and a dollar collapse. Protectionism and geopolitical uncertainty could also be harmful.

Nevertheless, interest rates have peaked and the next move for the US Federal Reserve will be a cut. If it happens, it’s likely to occur in the context of a slowing economy. But such a move would technically mark the beginning of another leg down for borrowing costs.

The question then is whether consumers will take advantage. That can’t happen if the economy “feels” as if it’s in recession, even though it’s not technically in one. Also uncertain is how corporations will react to an earnings slowdown brought on by a weaker economy.

I expect corporate earnings won’t be affected as severely because labor costs–the most important corporate cost–remain subdued.


Source: Bloomberg

There’s no bulletproof assessment of the impact of 2007 US economic growth on the rest of the world. (My current reading is for a 2 percent GDP growth in 2007.) Be careful to balance optimistic and pessimistic views: Don’t be overly bullish or bearish.

I’m cautiously bullish as I prepare to set the SRI Portfolios for next year. I expect stocks to outperform once again, but you’ll have to carefully navigate, as you did in 2006, the dangerous waters of the investment world.

Portfolio Moves

I’m taking some profits off the table this week, beginning with Danone Group (NYSE: DA). The stock has performed quite well since its recommendation in mid-March, having returned a little more than 33 percent. But there are better opportunities right now in Europe; I’ll be adding some new European stocks soon. Sell Danone.

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

Both stocks have proven the merits of adding them to the SRI Long-Term Portfolio. ICICI–recommended on 2006 June 21–is up around 52 percent, while Dr. Reddys–recommended on 2006 February 15–has gained 28 percent. it’s simply a matter of prudence to take something off the table; no one ever lost by booking profits.

Both stocks will remain in the SRI Portfolio because this is a long-term diversified portfolio and the secular bull story in India remains intact. Allocate the proceeds to other Portfolio picks or hold on for investment in new SRI recommendations.