It can be dangerous for investors to be sitting on positions that have achieved all-time highs. And that’s what’s happening in Asia: The MSCI All Country Asia ex-Japan Index, the region’s benchmark, recently surpassed its previous record, established 12 years ago.

Although the view may be beautiful from the rooftop, the fact of the matter is that Asia will once again be at the center of liquidation activity when investors decide--or are forced--to take profits.

Tactically, this is the reason why I’ve been recommending taking some profits off the table in Silk Road Investor, my subscription-based global financial advisory.

The serious bearish case as 2007 gets underway--distinct from the perma-bear rubbish fed by “intellectual” advisories for the past year and a half now--has two main parameters.

The first is the thought that the expected economic slowdown in the US could prove to be a severe recession. A more serious unraveling of the housing market, the theory goes, will have severe negative consequences for the US consumer. It’s further argued that the financial system has become much riskier than people want to believe, and therefore, a deflating housing bubble may have wider and more severe financial implications than is currently expected. There’s some talk of the worst crisis of the last 70 years.

The second parameter is China. The concern is that extremely strong growth has spurred high levels of inflows, which, in turn, has led to a lot of poorly conceived investment projects and created excesses. At the same time, a big part of corporate China could be facing profitability problems, given reported wage growth and a shortage of skilled labor, on top of rising commodity pricesI have no problems with that version of the bearish argument. For starters, if there’s a severe recession, all bets are off in the financial markets. Investors who think such an outcome is highly probable should liquidate their positions in Asia and everywhere else, buy gold and wait.

For the time being, and for reasons I’ve previously expressed, my view is that the deep recession scenario isn’t in the cards.

I laid out my views on 2007 in the last SRI issue of 2006

Though global markets had a great 2006--particularly in the last six months--the future looks a little murkier now than it did 12 months ago. For this reason alone, you should be careful to balance optimistic and pessimistic views heading into 2007: Don’t be overly bullish or bearish.

I'm cautiously bullish as I prepare to set the SRI Portfolio 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.

My overarching assessment for 2007 is that the global economy will slow--perhaps substantially--at some point as a natural outgrowth of the downturn that started in mid-2006. It won’t result in a deep recession, though, and global economic growth will resume.

I pay special attention to the bearish economic case for 2007 because it has merit and I agree with quite a few of its main arguments, particularly the point that a US housing slowdown is a potential contagion for that economy and, consequently, the global economy.

The bottom line, though, is that investors will be able to enjoy good returns in 2007. The key is being correctly positioned and understanding that “good performance” isn’t defined by a straight line higher. Be prepared for volatility.

I once again expect Asia and other select emerging markets to outperform developed economies.

As noted above, Asian markets could correct--substantially so--if only because of profit-taking or an attempt by investors to take a breather. More important, they could correct because of a slowdown in global economic growth, as I expect.

Indications of the latter aren’t difficult to see. Consider that Korean exports--the earliest available measure of global manufacturing activity--came in below expectations in December (13.8 percent instead of 18.7 percent), indicating the global trade cycle may have peaked. Asian exports remain a better way to gauge shorter-term changes in Asia.

The China argument remains more convincing. It’s well known that that excess supply of capital--a problem afflicting China--leads to bad investment choices and, eventually, a readjustment period.

I don’t know when this adjustment will take place, but I’m well aware of investors’ seemingly insatiable appetite for Chinese exposure. My advice is to avoid financial stocks (banks, insurance, etc.) in China.

Investment Thoughts

The long-term Asia story (as outlined in The Silk Road to Riches: How You Can Profit by Investing in Asia’s Newfound Prosperity, a book I co-authored with two of my colleagues) is still intact. Far-sighted investors should have serious exposure--to the tune of 30 percent to 50 percent--to the region, including Japan, depending on their individual risk characteristics and investment horizon. This allocation recommendation assumes a well-diversified portfolio, the purpose of which is to reduce overall volatility as some assets appreciate while others depreciate.

The SRI Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent. The areas I’m looking at for investment ideas continue to be property, infrastructure, financials, retail, telecom and power generation. Infrastructure is also an extremely important aspect of the investment strategy.

Korea could be the surprise of 2007 in terms of economic and market performance. The market, the second-cheapest in Asia after Thailand, was a weak performer in 2006. And although exports are slowing, the economy seems to have more strength than previously thought.

Given that most fund managers don’t want to own too much Korea, there’s potential for a re-evaluation if positive news emerges, because all the negative news should be priced in by now. I prefer to get Korean exposure through its banks; as a sector, they trade at a substantial discount to the rest of the region.

A Look Ahead

It seems like only yesterday that people around the world were finding eccentric ways to celebrate the new millennium. As we’ve passed the midpoint of the new millennium’s first decade, investors continue to ignore the fact that developing economies around the world are gradually assuming global economic growth leadership.

I expect this substantial change will continue--along with necessary booms and busts along the way--for a long time.

The developed economies are still the most important ones for the stability of the global economic and financial system, but real growth will only be found in emerging ones. And going forward, the serious emerging economies will be able to institutionalize themselves and increasingly become a more substantial force in the global economy. Investors who are able to identify and understand the above dynamic will come out on top as the story unfolds.

At the dawn of 2007 Asia, Japan and Russia are still my favorite markets. The SRI Portfolio remains concentrated in domestic-oriented companies (particularly when it comes to Asia and Japan), while most of the remaining recommendations stand to benefit from the global economic changes discussed above.

Yiannis G. Mostrous is editor of Growth Engines.

© 2007 Yiannis G. Mostrous
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