Last month, we noted that the Dow had climbed above 10,000, in the process establishing another new record high. As of that date, it was up 7% on the year. Since then, the index has maintained its rocket-like characteristics, tacking on an additional 1,000 points in less than a month. It advanced 28% in 1996, 20% in 1997 and 16% in 1998. It is now up 20% in 1999. Compare these numbers with the respective earnings generated. The Dow has now experienced 8 consecutive years of gains, the longest string in its 100 plus year history.

Last month, we shifted our long-standing, ultra-cautious bearish stance to a more aggressive ursine perspective. While our specific short/put suggestions (MU, AMAT, IRID, INTC, GTW, DELL) have faired reasonably well, given the apparent strength of the indexes during April and May, subscribers may be forgiven for questioning the sanity of your editor. While we could legitimately argue that the advances in the more senior indexes have been "narrow" to say the least (five stocks accounted for half of the gains recorded in the S&P 500 in Q1, AOL and MSFT accounted for a third of the rise), this month, we deliberately donned rose-tinted glasses through which to review the global economic situation, quite prepared to cheerfully join the bullish legions if a case for near-term optimism could be found. We are well aware of the fact that stock markets are "discounting devices", hence the perspective we maintained was that surely there must be signs that deflation is on the wane or that the globe is showing signs of economic rejuvenation. Unfortunately, facts that might support such optimism were not in evidence. If anything, further deterioration was found at almost every turn. With markets rising while economic conditions worsen, a bearish stance is mandated.

Japan - The Global Banker In Distress

While most investors recognize that Japan is the world's second largest economy, many are unaware of the fact that for decades, it has fulfilled a far more important role, that being "banker to the world". Courtesy of an export-oriented economy, the prodigious savings rate of its citizens (30% per annum), and bank capitalization requirements that were "liberal" in the extreme, Japan has provided the lion's share of the capital that has financed much of the Western world's government deficits, most of Asia's growth, and a significant portion of the free world's expansion, all at remarkably low interest rates.

Unfortunately, this happy state of affairs is at an end. Japan is on the ropes and can no longer afford to fulfill this role. Bad loans have destroyed much of its excess capital and that which is left is required at home to (hopefully) refurbish a badly mauled (essentially insolvent) banking system.

The implications that result from Japan's emaciated economic status are both massive and foreboding. Obviously, until Japan recovers, there is no possibility of a recovery in Asia. Rebuilding requires capital, Japan has little to spare, and alternative sources of serious capital are not in evidence. Making things worse, many foreign stock markets have rebounded strongly, as funds have poured in seeking "bargains" and "momentum" investing has taken hold. Some offshore stock markets have regained 85% of their former highs, in spite of abundant evidence of a continuing debacle.

The evidence suggests that rebounding foreign stock markets are "premature" to say the least.

• Hong Kong's economy contracted 6% in 1998 and will fall at least another 3.5% in 1999.
  
  
• China claimed economic growth of close to 6% in 1998 (which is a far cry from the 12-18% growth of preceding years), but few Asian experts see this as more than smoke and mirrors. Manufacturing capacity utilization is running at 50% and unemployment is rising explosively. Even optimistic Chinese government officials expect "minimal real economic growth" in 1999.
  
  
• Indonesia is wracked with riots and insurrection, even as its once vibrant economy continues to shrivel. More than 1,000 Indonesians have died so far this year in clashes among nationalistic movements, religious organizations, political parties and ethnic groups. Unemployment is exploding.
  
  
• S. Korea, one of Asia's few bright spots, is struggling with labour strife and general strikes. The S. Korean economy contracted 6% in 1998 and will likely decline a further 4% this year.
  
  

Russia recently allowed that it would default on its Ministry of Finance Bonds ("MinFins") in May. There is more here than meets the eye. These were the bonds on which the government had hoped to rebuild credibility. The fact that even the "MinFins" are worthless speaks tellingly of the worsening Russian economic crisis.

• A similar dichotomy between economic reality and stock market chutzpah is evident across much of Latin America. In Mexico, even as the Bolsa has vaulted 40%, retail sales have tailed off and unemployment has inched upward. Much nastier economic numbers continue to ooze out of Argentina (industrial production down 10%), Brazil (free-falling industrial production, rising government deficits), Argentina (again, slumping industrial production, rising unemployment), etc.
  
  

Behind all of this, the grim but necessary task of "washing out" much of the excess manufacturing capacity that still plagues the planet has barely commenced. While Asia can ill afford another round of wealth sublimation, follow-on stock market crashes are inevitable in several regions as the fundamentals underlying recent share price advances are in tatters. Dead cats don't bounce very high.

Given the above, the key question then becomes, where does the world find a new banker, especially one as accommodative as was Japan? Bluntly, none exists, hence we see this as one of the fundamental elements that will influence world economic activity for the next several years and one that serious investors should keep in the forefront of their thinking. Unless or until Japan revives, much of the globe is doomed to mediocre growth and survival-based economics.

That Japan continues to falter is evident in recently released figures, which compare poorly with preceding crummy numbers. Production in factories and mines plunged 7.1% in 1998, the largest fall in 24 years. The decline was attributed to falling demand (particularly in cement and steel) and deteriorating capital investment. Monthly results since year end appeared to initially slowly revive, but then fell again harshly in March. Tokyo's March department sales were down 8.5% (y-o-y) and 4.3% sequentially (vs. February). Official unemployment stands at 4.6% (a modern day record for Japan) but the actual level of unemployment is likely to be close to double this number. Real estate prices continue to slowly unwind. Bad loan estimates continue to hover in the 40%-of-GDP range. The country is mired in the worst recession it has experienced since World War II. And oh, yes, the Japanese Central Bank continues to be a net seller of U.S. treasuries, as it was for much of 1998.

Japan's low interest rate policy continues unabated and as in the past, continues to create more problems than it solves. Originally intended as a means by which its ailing banks might be re-liquified, it has instead applied pressure on the Yen, and increased capital outflows. Disgruntled Japanese investors, now free to roam the world in search of better returns, are doing just that, in the process selling Yen for alternative currencies. The U.S. has encouraged Japan to print more money, increase government deficits and increase credit availability. While such actions usually stimulate the economy in the U.S., it is a prescription for a disaster when applied to Japan. In the U.S., reduced interest rates engender increased borrowing and increased spending. In Japan, just the opposite occurs as Japanese savers reap a lower return on their capital and perceive the need to save even more as a result. U.S. advisors to Japan have not factored in the powerful cultural differences and the advice they proffer is worse than useless. Japan's economy will continue to slide inexorably until its economic policies are shifted. At best, it will take considerable time, at worst it will occur after calamity strikes.

Japan's trade surplus shows no signs of abating. While the uninitiated may think of this as a positive for Japan's economy, it is the opposite, as Japan's trade surplus depresses its GDP. To understand this, consider the export of an item from Japan that is sold to the wholesaling foreign purchaser for $10. Thanks to the pressure on the Yen emanating from the low interest rates found in Japan, the acquiring firm converts its currency to Yen at a premium. In effect, it acquires the item at a discounted price. But that is just the initial "hurt" for Japan. By the time that particular item has moved through the distribution process and reached a consumer, it will sell for say $60. The excess of $50 is a part of the GDP of the importing nation. If Japan had been able to sell the item internally, the $50 would have contributed to its GDP. No wonder the U.S. GDP holds up so well, even as its trade deficit soars. Incidentally, Japan's economic figures support the above-noted conundrum; Japan's GDP growth rate correlates inversely with its swelling trade surplus.

Pressure on the Yen is having other nasty consequences. A falling Yen re-prices all loans denominated in foreign funds and increases the losses associated with foreign denominated "bad loans". It also triggers a higher foreign borrowing premium (the "Japan Premium" - see earlier issues) for the Japanese banks. Additionally, it causes Japanese banks to call in even more loans (to maintain capital ratio requirements) which squeezes involved Japanese businesses. This is not a virtuous cycle.

1999 should be entitled "The Year of the Print" with respect to Japan, as the government intends to sell the largest bond issue in its (or any other entity's) history (31.0 trillion Yen). Aside from exacerbating an already worrisome deficit, the inflationary aspects of this action will be massive. The Japanese government hopes to "globalize" the Yen, (i.e., sell its bonds across the planet), intending to mimic the actions of the U.S. government in recent decades. Unfortunately for Japan, a clone of itself does not exist, hence it will not find the willing, generous and pliable "World Banker" that so accommodated the U.S.

(Part - 2 next week)