South East Asia and Oil are the best buys now!

The US stock market has continued to rally strongly but part of these gains have been mitigated for foreign investors by the continuous decline in the value of the US dollar, which has now depreciated by more than 30% since the beginning of 2002.

And while eternally optimistic guest commentators on CNBC only addresses the rather embarrassing subject of a collapsing dollar seldom, when it is addressed it is always in a positive context, such as: a lower dollar makes American manufacturers more competitive and that, as a result of weakness in the dollar, the earnings of the multinationals will rise.

However, I believe that the dollar would have to depreciate at least 50% against the Asian currencies ex Japan in order to have an impact on the existing trade imbalance between the US and Asia including China and India. Since 1985, the dollar has declined from around 250 Yen to 116 Yen, and we have not seen an improvement in the trade balance with Japan. And a revaluation of the Asian currencies of such a magnitude isn't likely to occur for the time being.

Moreover, I'm not so sure that a weak dollar will boost the earnings of the multinationals by as much as analysts expect, simply because the overseas economies have been weakening over the last six months or so. According to the tax based NIPA data, foreign-based profits fell by 30.7% in 2002, despite a 5% decline of the US dollar in trade-weighted terms and 15% decline against the Euro.

Still, because of the weak dollar, companies such as McDonalds and Procter & Gamble could report higher sales and earnings than had been expected. Without the dollar's decline Procter & Gamble's sales would have been up by 5% and not as reported by 8%, while McDonald's sales would have risen by just 1% instead of the reported increase of 5.6%.

I may add that for MacDonald same store sales, at stores open for more than one year remained almost as unappetizing as its horrible hamburgers, since they declined 3.6%! Also, considering that in Asia, where 58% of the world's population lives, the markets for many consumer goods are far larger than in the industrialized countries, and where growth potential is the highest, the impact of SARS on consumption and, therefore, also on the earnings of multinationals will become a factor.

There is another point, which makes me cautious about the outlook for the corporate sector in America, despite a lengthy program on CNBC during which numerous 'very good news economists' were interviewed and the CNBC commentator concluded that, 'corporate America is healthier than you think'! If indeed the overseas economies are weakening - and this seems certainly to be the case in Europe and much of Asia - then excess capacities will continue to put pressure on prices.

At the same time, costs for insurance, healthcare, depreciation charges, and pension funds are rising rapidly in the US and could, therefore, continue to squeeze corporate profits. And, while it may be true that there has been a slow improvement in credit quality, overall the corporate profit picture is far from rosy. The main problem is that in 2001, net fixed investments declined from $407.3 billion in 2000 to $268.1 billion, as a result of lower gross investments and sharply higher depreciation charges, which led to the recent profit squeeze.

In 2002, the net investment position worsened further, because gross fixed investments in the non-financial sector fell by another $84 billion while depreciation charges increase by another $40 to $50 billion, which would have lowered net fixed investments to just around $100 billion and is quite negligible compared to the $10 trillion US economy.

So, while the corporate sector is slashing its capital spending, it is the least desirable adjustment for the US economy, since long term growth and profits in an economy can only come from net additional capital investments and not from consumption. Just consider that in 2002, merchandise imports rose by 11% against a GDP growth rate of just 2.4%. In other words in 2002, imports rose almost five times faster than GDP.

Now, some US strategists (almost all of them) are arguing that corporate balance sheets and cash flows have improved significantly over the last 12 months. But, as Dr. Kurt Richebacher pointed out in a recent commentary concerning cash flows, 'it is necessary to distinguish between two different components of totally different quality: depreciation charges and undistributed profits. First of all, depreciation charges are expenses, and second, they derive from obsolescent capital stock needing replacement.

In reality, retained earnings are the only freely disposable component of cash flow. Also called business saving, they alone represent a net financial gain for the firm. But this component of corporate cash flow in the United States has collapsed. Any increase comes from soaring depreciation charges. What has happened to business savings net of depreciation charges is an outright disaster that most observers have yet to notice.

Until the latter 1970s, they equaled on average 2.9% of GDP. In the late 1980s, that was down to 1.8% of GDP. Lately, however, it is zero for business as a whole' (emphasis added). According to Dr. Richebacher, 'retained earnings have not only disappeared, but they have turned heavily negative because the companies are paying dividends increasingly in excess of their earnings. In other words, a sharply rising part of dividends is met with borrowed money.'

In this respect we note that corporate net interest expenses are now running at an annual rate of more than $190 billion, comparing with $119 billion in 1997. But after-tax profits were then around $300 billion, as against $190 billion currently.

Moreover, whereas in 1997, non-financial corporations paid $218.1 billion in dividends from $337.7 billion in after-tax profits, in 2002, they paid dividends of 258.8 billion compared to profits of only $197.0 billion, which meant that US companies have been financing increasingly their dividends by either drawing down their cash reserves or by borrowings. Therefore, 'outsized dividends' may now prevent an even steeper decline in stock prices, but at the cost of balance sheets, which instead of being repaired are further rampaged.

There are other reasons for some caution about several sectors of corporate America. In the mid 1990s, I wrote a report entitled, 'What happens when the Marlboro Man falls off his horse' and followed up with a reports entitled 'Are the Multinationals Set to Stumble', in which I made the point that private label goods would increasingly eat into the market of brand products and erode their profitability. In the case of the US tobacco industry this has certainly happened, since the market share of 'deep discount brands' has risen from less than 2% in the mid 1990s to 10% at present.

As a result of the proliferation of cut-price brands R.J. Reynolds surprised the market with a first quarter 2003 net profit decline of 53% (sales dropped year-on-year by 20%), while Brown and Williams, British American Tobacco's US subsidiary reported a profit decline from $126 million a year ago to $63 million in this year's first quarter. The point is that, for many branded goods companies, the competitive environment has intensified because, in a sluggish economic environment, the consumer becomes more cost conscious and local brands in overseas markets frequently gain in popularity.

In China, TCL, a manufacturer of TVs, which started making cellular phones in 1999, has already overtaken Siemens and Samsung to become China's third largest handset vendor after Motorola and Nokia. And, whereas local brands such as TCL, Ningbo Bird and Amoisonic had less than 3% of the handset marketing 1999, today the more than 30 manufacturers of domestic brand control already more than 26% of the market. (I also think that because of overcapacities, many multinationals will be disappointed by their business in China).

I might add that even Levi Strauss, which for years took large retailers to court for selling their jeans at discount prices, recently introduced 'Signature' trousers, which will be sold through Wal-Mart and other mass market retailers (Signature jeans cost about 80% less than Levi's). But cut-price brands and generics in the pharmaceutical industry aside, I am also concerned that pirated goods will make further inroads in many product lines. In 2002, world music sales fell by 7% (the third consecutive decline in annual music sales) because of rampant illegal Internet downloading and compact disc copying. (In this instance the Internet has boosted the productivity of 'pirates' at the expense of the leading music and entertainment companies.

So, while I believe that the current rally in US stocks may last for another few weeks, a serious setback should be expected in the second half of the year once it becomes more obvious that US corporate profits will continue to disappoint and once interest rates reverse their decline and start to rise.

In the meantime, I remain very positive about the Asian stock markets for a variety of reasons. If we look at the performance of stock markets around the world year-to-date, what is striking is that, whereas the best performing markets were in Latin America, some of the worst performers are to be found in Asia where India, Japan, South Korea, Taiwan and Hong Kong were all down double digit, as at the beginning of May. Now, it is a fact that SARS had, and continues to have, a negative impact on the Asian region (although both Indonesia and Thailand have performed satisfactory), but I look at SARS as follows.

If the disease turns out to be a major problem, then the SARS pandemic is likely to spread around the entire world in due course and will therefore also have a very negative impact on the highly priced US stock market. If, on the other hand, SARS is only a temporary phenomenon, then the Asian economies, which undoubtedly are suffering from the SARS scare, are likely to recover from their current lower growth rates, which came about from less traveling and reduced consumption.

In particular, the Taiwanese stock market, which is at the current level significantly lower than during the Asian crisis of 1997/1998, would seem to have strong rebound potential. Investors may consider the purchase of the Taiwan Fund (TWN) and the Korea Fund (KF) both of which are listed on the NYSE and sell at a discount of more than 15%. An alternative would be to buy the exchange traded South Korea (EWY) and Taiwan (EWT) funds, which respectively track the MSCI indexes of these countries.

Personally, I have a preference for the South East Asian markets. As I have explained repeatedly in the past, Japan, Taiwan and South Korea will increasingly be squeezed by China, where production costs are far lower. Conversely, South East Asia with its large natural resources is in many sectors complementary to China. As a result, I still like Indonesia where the economy is performing satisfactory and where we find numerous inexpensive companies.

We still like P T Telekomunikasi (listed on the NYSE: TLK), and smaller companies such as Indofarma (INAF.IJ), Ciputra Surya (CTRS.IJ), Enseval (EPMT.IJ), Mayora Indah (MYOR IJ), Lautan Luas (LTLS.IJ) and London Sumatra (LSIP.IJ). I also feel that the Indonesian banking sector has good recovery potential.

What encourages me particularly about the outlook for Indonesian equities is that the net capital flows have recently turned positive. In fact, I would argue that SARS may have a beneficial impact on the flow of foreign direct investments (FDIs) into some countries, because multinationals have become aware of the danger of relying too heavily on investments and supplies from China. Therefore, some FDIs, which before the crisis would have been made in China, may now flow to some other Asian countries.

For an exposure to Thailand, we continue to recommend the purchase of Bangkok Dusit Medical Services (BGH TB), Thai Union Frozen Products (TUF TB), Banpu (BANPU TB), Ocean Glass (OCG TB), and GFPT (GFPT TB). An overlooked and by foreigners shunned market is the Philippines. However, it has been my experience that the stock market frequently follows the Latin American markets and, therefore, given the strong performance in South America, a strong bounce could occur in Philippine stocks as well.

There we still like Ayala Land (ALI PM), Jollibee (JFC PM) and ABS-CBN (ABS PM) In Hong Kong, we like Swire Pacific (19 HK), TVB (511 HK), Next Media (282 HK), Shangri-la Asia (69 HK) and Hong Kong & Shanghai Hotels (45 HK), and in Singapore, Singapore Telecommunications (ST SP), Singapore Airlines (SIAL SP), Singapore Technology Engineering (STE SP) and Capitaland (CAPL SP).

I should like to stress that I have a high degree of confidence that diversified portfolio of Asian equities can be sold sometime within the next five years with a significant capital gain, while in the meantime one is paid for waiting because of the high dividend yield Asian equities provide (I own directly or indirectly some of the equities mentioned).

Incidentally, I also believe that we have just made a major low in the Japanese stock market. Blue chips and religious stocks like Sony have totally broken down, which is usually a sign that the bear market is approaching its end. I maintain my earlier recommendation that 2003 is the year when investors must go long Japanese equities and short Japanese bonds. It is only a matter of time before investors will pull out money from the ridiculously priced bond market (yielding less than 0.6%) and buy equities.

At the same time, I have less confidence that the purchase of the S&P 500 above 950 will produce satisfactory returns over the next five years. Still, I continue to like oil companies, whose earnings in the first quarter were superb, oil servicing companies and gold mining companies. Stocks like Royal Dutch (RD), Chevron Texaco (CVX), Exxon (XON), Woodside Petroleum (WPL AX), Schlumberger (SLB), Diamond Offshore (DO), Newmont Mining (NEM) and BHP Billiton (BHP) should be accumulated.