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July 2, 1998

July 2, 1998

We have been noticing several trends that point to the ongoing change and evolution in the world markets in 1998. These trends are greatly shaping the investment environment for 1998 and future years.

(1) The bigger, the better. The U.S. market has been excellent for big cap stocks, average to poor for mid sized companies and terrible for small companies. For example, during the U.S. market correction from April 13 to mid June, the Dow Jones Average fell less than 10% while 60% of all stocks listed on NASDAQ fell by over 20%. This decline by the small capitalization over-the-counter (OTC) market qualifies as a bear market in small company stocks. We bring this to your attention, because it indicates how narrow the market advance has been.
The world news background is highly variable and this leads to insecurity and fear. Insecure investors have crowded into the biggest and most liquid companies and abandoned most other companies. This has left many forgotten and undervalued mid and small sized companies. Although investors are able to find value, and it is tempting to research and invest in these small companies, it is not practical because they are unable to attract big institutional buyers. Until global institutional investors begin to seek out smaller and less expensive companies, they will remain undervalued, and will continue to underperform the large companies.

(2) Europe strong, Asia weak. Outside the U.S., Europe is doing well, but Asia is doing very poorly. Europe is doing well because of a confluence of positive events such as lower taxes, stock buy backs, takeovers, labor concessions, the advent of the EMU and the outlook for increased European competitiveness. The effect of these is to increase European profits. On the other hand, most Asian markets are down over 30% on the year. Asia is declining because of a litany of fears and serious government and corporate mismanagement, which have led to higher interest rates, price cutting, and slowing demand for major products. This combination has led to lower corporate profits and lower price earnings ratios as investors substitute bonds and foreign stocks for Asian stocks.

(3) Dollar strong. Currencies are generally weak versus the U.S. dollar and will remain weak as long as the Asia crisis continues. Most importantly, though, Japan must make long term changes in its style of functioning. Changes that are not easy to implement because of their cultural importance. If Japan does not make these changes, the crisis in Asia will continue and possibly escalate.


THE GLOBAL MARKETS

The Asian and emerging markets have been battered, declining in some cases up to 80% in U.S. dollar terms. These markets have declined, partly because investors have sold local stocks and converted their cash into other currencies and purchased large U.S. and European stocks. This has made big stocks in these regions very expensive. High valuation alone does not mean a major correction will occur in the U.S. or Europe, but it means volatility will continue and even grow. This volatility will create a need to swim against the tide, to buy on substantial declines and to avoid euphoria during market rallies.


CURRENCIES

The U.S. dollar will remain strong especially versus Asian currencies. The Asia currencies and economies can recover if: (1) Japan can stabilize its banking system by an orderly liquidation of bad loans and insolvent banks; (2) if the Chinese are able to maintain the value of their currency, that is, avoid devaluation. If the Japanese process is not dynamic and Japan continues to muddle ahead with no decisive action, then we could revisit the Asian crisis with a weak Japanese yen, a weak Chinese yuan and other Asian currency devaluations in the fall of 1998. These competitive devaluations will cause even more depressed economic conditions in Asia.


INTEREST RATES

Lately, interest rates have been falling in the U.S. and Europe. In the U.S., because of the flight to safety of money into U.S. dollar based bonds from Asia, and in Europe, because of the changes taking place with respect to the “Euro.”
As always, we are keeping an eye on interest rates and these trends, as they will undoubtedly have a profound effect on the markets.


SUMMARY

In summary, 1998 has been a tricky year. U.S. and European large stocks have done well in general. Among the winners have been consumer financial and software stocks. Cyclical stocks have done less well, with chemicals, semiconductors, metals doing poorly.

We are focusing on industries with high visibility of good earnings and with low exposure to the Asian problems such as the pharmaceutical industry, software, and retailing. These are our preferred areas of investment. We are avoiding Asian stocks, and other emerging market stocks, small stocks, as well as, companies that are impacted by lower commodity prices and Asian troubles.

Please accept our warmest wishes for a healthy, happy and prosperous summer. Don’t hesitate to call if you have any questions, comments or ideas.