FALLS CHURCH, Va.–According to the Chinese Zodiac, 2008 is a year of danger. And although superstition isn’t good company for an investor, last year was quite rewarding, just as the Chinese Zodiac forecast.

Nevertheless, caution is warranted. The subprime crisis has turned into an assault on the world’s credit structure, but the synchronized efforts of central banks will keep the system alive. The markets aren’t powerful enough or willing to fight the central banks of the world, especially when they act in concert.

This doesn’t mean the global economy won’t slow or the US will avoid a recession of some sort. All it means is the world’s financial system won’t collapse.

For the Silk universe, however, things are a bit more complicated. Our markets finished their fifth year of absolute performance dominance versus the rest of the world. For that reason, this year may require a little more agility than 2007.

My new market preferences for 2008 are as follows: Russia, Hong Kong, South Korea, The Philippines, India, China, Singapore, Malaysia, Taiwan, Europe, Japan and Macau. Take a look at the Fresh Money Buys below for details on stocks.

For details on Russia, see Silk, 19 December 2007, Russia: Top 2008 Market. South Korea should be positive as the new leadership starts settling in this year, and I recommended staying with the domestic demand stocks, namely banks and utilities. See Silk, 26 December 2007, Politics Matter for more.

I’m rounding up the top three with Hong Kong. I’ll take a more in-depth look, with a few new stocks, next week. With inflation rising, Hong Kong will have negative real interest rates for some time.

Because of the currency peg, Hong Kong will most likely follow the US rate policy, leading to a large amount of funds being injected into the local economy, especially as long as the mainland remains strong. This will benefit the real estate market.

Although real estate is a cyclical industry, in Hong Kong’s case, there’s strong, pent up demand given the low transactions in the past two years, especially in the low end of the market. So Hong Kong can experience another more structural leg up in real estate, which was the case between 1985 and 1997 when prices rose by 720 percent. Portfolio holding Cheung Kong (Hong Kong: 1, OTC: CHEUY) will benefit from such a move.

Portfolio Performance

The Silk Long-Term Holdings Portfolio continues to outperform.

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. Also note that this performance doesn’t include the Alternative Holdings Portfolio return.

Though quarterly results aren’t my main concern, the end of the period offers an opportunity to assess performance since inception.

Since its inception 15 February 2006 through the end of 2007, the Portfolio is up 60.7 percent, while my benchmark–the Morgan Stanley Capital International All Country World Index Total Return (MSCI World Index), which includes gross dividends–is up 31.5 percent. The S&P 500 is up 18.42 percent, including dividends, during the same time frame.

Source: Bloomberg, Silk

The three permanent hedges–US Treasury bonds via the iShares Lehman 7-10 Year Treasury Fund (AMEX: IEF), recommended in early March (see Silk, 8 March 2006, Hedge Your Bets), streetTRACKS Gold Trust (NYSE: GLD), recommended in late March (see Silk, 29 March 2006, Right You Are…), and the short on Consumer Discretionary SPDR (AMEX: XLY, see Silk, 6 December 2006, The Money Month)–continue their respectable contributions to the Silk returns.

Bonds were up 15.2 percent since first recommended, gold has gained 44.5 percent, and shorting the American consumer has turned out a profit of 13 percent. Notice that this last position is a leveraged hedging short to a long-only Asia overweight portfolio and should be viewed as such.

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

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

Source: Bloomberg

It’s imperative that I mention gold here, given my long-held bullish view on the metal.

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 de-leveraging of the consumer). However, 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), it’s 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 five years ago (while overseeing a portfolio for another advisory), and the metal remains the ultimate bulwark. Gold 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.

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

The Short Trade

During the November market turmoil, I recommended shorting the Chinese insurers (see Silk, 13 November 2007, Flash Alert: Hedging the Portfolios).

My recommendation for investors who prefer to be involved with stocks that trade in the US was China Life Insurance Company (NYSE: LFC). The profit is 10.4 percent as of 31 December 2007. The alternative short was PICC Property and Casualty (Hong Kong: 2328), which has also done well with a 18.5 percent gain.

If you have entered the trades, stay with them and have your stops at break even. For China Life Insurance Company, an Alternative Portfolio holding, this means a stop/loss order at USD85.

Remember that those are hedging trades in a long-only portfolio.

Portfolio Moves

Today I recommend selling Datang International Power (Hong Kong: 991, OTC: DIPGY), where we have an almost 70 percent gain since my original recommendation. Although I still like the long-term story, the stock may be weaker than expected shorter term. Sell Datang International Power.

Fresh Money Buys

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio pages on the left-hand side of your screen for details.

• Russia (energy, telecommunications)
• Hong Kong (real estate, banking, infrastructure)
• South Korea (banking, electric power)
• Philippines (telecommunications, real estate)
• India (pharmaceuticals)
• China (consumer, coal, e-commerce, oil, water)
• Singapore (banking, telecommunications, industrial)
• Malaysia (ETFs)
• Taiwan (technology, telecommunications)
• Europe (industrials, communications equipment)
• Japan (banking, industrials)
• Macau (gaming)