LONDON–It’s been a little more than four months since my last visit to this fine city, and my long-held view that London is a stimulating international investment environment is being reinforced this week.

A diverse group of people are found here. That they’re fairly free of half-truths in their thinking makes for stimulating conversation on international finance and geopolitical developments alike. The perspective in London is truly global.

At this time of the summer, attitudes turn to leisure while much of the investment community is either still on vacation or on the golf course. Nevertheless, I had an opportunity to “eavesdrop” on some of my investment professional friends over dinner. Here’s how some of the sell-side guys described market events of the last three months.

Even before the May selloff, markets were fairly uneasy; and once the selling started, a lot of hedge funds began going short. The idea was that, given the amount of significant long positions, someone would, at the end, be left holding the bag.

But although the short trade worked initially, the market as a whole was more eager to rebound than go down. Many “shorts” held on at the outset; but after a couple weeks of building, the pressure forced them to start covering their positions, adding fuel to the market rally. They also bought fairly heavily–short-term performance is important to them and they can’t afford to stay on the sidelines.

My friends argued that the majority of the big money is looking for a rally and is positioned accordingly. No one knows what will really happen, but things don’t look too bad.

These insights provided enough information for me to get an idea of the sentiment among the big players here in London. And although I’ve been promised a more elaborate discussion upon my return (after a short trip to the Continent), I have no complaints about the value of our conversation.

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.

This assessment would obviously be proven totally wrong if the anticipated slowdown devolves into a global recession next year. Although I’ve written about the possibility of this scenario materializing (see SRI, 8 March 2006, Hedge Your Bets), global economic growth still looks strong (it’s slowing, though), global labor costs remain low, inflation (though it’s on the rise) is still fairly stable and low by historical standards and will play a positive role in holding interest rates lower than would otherwise be the case.

Finally, companies have fairly strong balance sheets, thus the excesses of past danger periods aren’t present for the corporate sector as a whole. At the same time, merger and acquisitions (M&A) continue on a strong pace, as excess cash needs to be put to work. Global M&A deals have surpassed USD2.1 trillion this year, comparable to 2000 on an annualized basis.

It’s possible that markets are underestimating the slowdown in the US economy, but it’s impossible to define with certainty those factors the markets have discounted and those they haven’t. It’s therefore extremely difficult to quantify any impact. At this juncture, I recommend constraint but not bearishness because the market can rally from here.



Source: Bloomberg LP

World markets enthusiastically digested the most recent US inflation data. The possibility that the US Federal Reserve might stop raising rates (recent comments by Fed officials to the contrary notwithstanding) is a positive, particularly for Asian markets.

I’ve discussed my views on inflation before (see SRI, 17 May 2006, Debating); my stance remains that a further increase in US inflation is possible, but ultimately the outcome will be deflationary given the amount of leverage in the system and the eventual adjustment (i.e., paying down of debt) such circumstances will require.

US government bonds continue to be a good hedge position. As I wrote in March (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’s 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 long only. Buy iShares Lehman 7-10 Year Treasury Bond Fund.

Keep that bit of advice in mind. Also, concentrate your Asian portfolio holdings in domestically oriented companies. In that respect, banks are prime candidates, and the SRI Portfolio includes several from the sector based in Asia: Thailand’s Bangkok Bank, India’s ICICI Bank, South Korea’s Shinhan Financial and Singapore’s United Overseas Bank.

If the market does rally from here, it’s obvious that higher-beta stocks will perform well. The Taiwanese market includes tech stocks that could advance in a potential rally, and it’s also out of favor with investors. It’s been said here before that Taiwan remains a politicized economy/market that could prove to be profitable in the longer term (see Geopolitics & Investing, 8 February 2006, The Dragon And The Eunuch).

Analysts have reserved their most pessimistic earnings assessments for Taiwan and expectations are therefore quite limited for the sort term. Yet the Taiwan Stock Exchange is up more than 5 percent off its early August lows–foreigners turned from net sellers of USD1.4 trillion in June and USD886 billion in July to net buyers of USD1.2 trillion in the first half of the month.

I must also note that Taiwanese companies have reduced debt; net debt-to-equity has fallen from a high of 37 percent in 1998 to 11 percent currently. In addition, the tech sector has increased supply discipline and is better equipped for a potential rebound.

Despite all the negativity regarding the economy and the market (a lot of it quite justified), Taiwan has been able to sustain its gradual upward movement, as the chart below depicts.



Source: Bloomberg LP

SRI Portfolio’s Taiwan exposure is through Chunghwa Telecom. It isn’t exciting, but it offers downside protection as well as a 7.4 percent dividend yield. Chunghwa Telecom remains my favorite long-term Taiwan holding.

The technology stocks I favor (in the case of a rally) include Taiwan Semiconductor (NYSE: TSM), United Microelectronics (NYSE: UMC), and AU Optonics (NYSE: AUO). International readers may want to take a look at Hon Hai Precision Industry (Taiwan: 2317). Absent a crashing US economy, adding some tech to your portfolio during the remainder of August and into September should prove to be a good move.

Finally, I’d like to offer an explanation regarding the way I view the investment process.

Many have come to SRI–with its emphasis on global markets, emerging markets in particular–to understand the argument that Asia will be a very important economic region in coming years. The next step is to contemplate that evolution and then act in a long-term fashion. Many investors have tried the “smart” way of trading Asian markets or have searched for the latest “hot” story to make a quick profit. These people ignore the big picture, and their profits are relatively small.

Long-term readers know that I haven’t positioned the SRI Portfolio in that manner and that I didn’t work like that when I was responsible for stock selection and sector allocation for another financial advisory. In other words, generating long-term, positive returns while avoiding short-term downside is the theory upon which I’m constructing the SRI Portfolio.

I make every effort to alert investors when I see moves to the upside or the downside or any other special situations (see SRI, 15 May 2006, Silk Road Investor-Flash).