Market View - January 1999

October 26, 1999

1998 was another banner year for equity investors. The major indices finished the year close to their all time highs and double-digit gains were again the norm. It's hard to believe that the blue chips could achieve such large gains from the unprecedented valuations of 1997, but they did. Perhaps that's because no one really cares what anything is worth anymore. As soon as a stock moves past the price target, the target is upped or the valuation model is changed.

To sum up the market action of 1998, it was essentially a battle between overvaluation, deteriorating global fundamentals, and easy money. A battle between fantasy and reality. Thirty percent of the world fell into recession or worse, U.S. corporate profits declined, banking systems convulsed, currencies collapsed, yet equity valuations moved further into the stratosphere. Central bankers seemed all too willing to prop up the financial excesses and expand them even further. Easy money and lower interest rates ruled the day.

1999 could prove to be a tougher investment environment. The "new era" profit growth that supposedly justified the historically high PE ratios of the last couple of years failed to materialize in 1998. In addition, earnings estimates for 1999 are already coming down. Almost everyone expects the U.S. economy to slow down a bit in 1999. That should put further pressure on profit margins. I suspect that even central bankers are concerned about the long-term economic implications of the runaway financial asset boom they have created. They should be. They have a tiger by the tail and there are no easy solutions. The stakes of the current game of financial hot potato are hard to ignore. The excesses can only be propped up for so long without the easy money spilling over into other bubble bursting conditions. In the mean time, more middle class money is moving into the market at prices that are sure to produce disappointing results or get wiped away in a crash. When the inevitable occurs, Wall St. and the Federal Reserve should be held fully accountable. There are fundamental flaws in our fiat monetary system that are at the core of these excesses. But reckless promotion from Wall St. and the inaction of the Fed except for monetary accommodation during the fall crisis are totally inexcusable. If the Fed was willing to use monetary policy to put out the fire in the fall, it should have been willing to use monetary policy to dampen the speculation in 1995 and 1996 when the party first started getting out of control.

Strategy for 1999

Caution remains the most prudent course of action for long term investors. The U.S. is in a financial asset and consumption bubble. There's an important distinction between saying that stocks are very high or overvalued and saying we are in an economic bubble. In a bubble, a significant amount of economic activity and earnings are based on sustaining the prevailing inflated asset prices and continuing the outsized capital gains. As a result, the income streams that investors base their valuations on are somewhat suspect. Earnings could decline materially in the event of a piercing of the bubble. That means that in some cases stock prices are higher than they actually look. I believe these circumstances require greater care in the selection of potential investments. Many small and highly leveraged companies that appear cheap at present could fair quite poorly in the event of a downturn. So could companies without a strong franchise or business position. I have only a handful of remedies for this situation.

1. Require a greater margin of safety in the price of the stock before investing.

2. Place strict limits on the types of companies that are eligible for investment.

3. Hold a much higher cash position than usual.

In my personal portfolio I am generally limiting my investments to companies with little or no debt, excess cash on the balance sheet and a strong franchise. I am also avoiding all economically sensitive industries. Unfortunately there are few bargains to be found given those limitations. Examples of the kind of companies I am looking at are Tootsie Roll Inc. and WM Wrigley's. Both are expensive right now, but they possess the qualities that investors should be looking for in an environment like this. They will do reasonably well no matter what the economic conditions. The strength of their balance sheets combined with their cash generating ability could also prove quite valuable if investment opportunities present themselves during bad times. Only the price is wrong at present.

My generally cautious stance on this market has been quite premature. However, I believe it has been both appropriate and prudent. It simply isn't possible to time these sorts of things on a consistent basis. Everyone from Washington, Wall St., Main St., the Federal Reserve, and option holding executives has a vested interest in keeping this bubble going. But investment decisions should be made primarily on value. Not on probable stock market action or short term bubble inflating solutions from Mr. Greenspan. There were a number of developments last year that could easily have triggered a severe bear market. Those risks continue today and in some cases have increased. If not for the aggressive but unsustainable actions of the Federal Reserve we would have experienced the bursting of the bubble in 1998. Here are the major risks:

The Japanese financial system is in very fragile condition. The daisy-chained nature of the world's financial system makes this a major concern. This is especially true with so many other countries in the region in trouble.

Brazil appears to be an accident waiting to happen despite the current efforts of the IMF. A meltdown will have a significant impact on the rest of Latin America and in turn the U.S.

Current IBES and First Call earnings estimates for 1999 are way too high.

The U.S. current account deficit is growing very large and the rest of the world now has an alternative for their foreign reserves in the Euro. The U.S. may have to pay higher "real" interest rates to attract the required savings needed to support the bubble.

Blue chip stock prices have never been higher and there is pressure on earnings.

With stock prices rising and earnings declining it's getting more difficult for some companies to repurchase as many shares with their free cash as they have in recent years. To solve the problem they are borrowing money, shrinking their equity and leveraging their balance sheets further. This is an unsustainable process and could prove quite foolish eventually even though it seems sensible at the height of prosperity. The resulting shrinkage in outstanding shares is temporarily supporting stock prices. However, the potential for a further weakening of profits or a less cooperative bond market for leveraged companies could put a halt to this process and remove an important stock market prop.

It's not clear what impact Y2K will have on global business activity even if the U.S. appears way ahead of the pack in addressing the issue. The first signs of what to expect should start appearing before year-end because a great deal of processing is future date related.

The clock is ticking on this bull and value investors should remain armed and ready! It's a rare time when valuations become so extreme that a truly defensive posture becomes appropriate. If ever in U.S. history there was a good time to take a few chips off the table, this is it.

Have a healthy and prosperous 1999 and above all be patient! The Fed is building a bubble from which there are no easy paths.
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