July 25, 1999
Dow Jones Average: 10911
S & P 500 Index: 1357
Interest Rates Rise
The prime directives of the Federal Reserve Board are to insure the
stability of the banking system, keep inflation in check, and promote
economic growth. When the Fed is able to simultaneously accomplish all
three objectives the financial markets are euphoric and the populace
quite content. It is not easy for the Fed to maintain a delicate economic
balance when the free enterprise system tends toward excess and speculation.
Inflation manifests itself in many ways. The Federal Reserve Board
fights inflation in all its forms, because rapid price escalation in
any area eventually leads to economic imbalance and boom-bust cycles.
While rising prices for food, fuel, clothing, medicine, and other staples
of life are a cause for alarm, inflation in real estate and financial
assets is often a source of national pride. That view changes abruptly
when property and stock prices reverse course leading to general economic
malaise.
The Federal Reserve decided to move against financial asset inflation
and incipient wage inflation in the summer of 1998, but was forced to
change course by the global economic crisis. While controlling inflation
and promoting growth are long term goals of the Fed, maintaining confidence
in the banking system is the one objective that takes precedence over
all others. Our entire economic system rests on the confidence and trust
depositors have in the banks and related financial institutions that
hold money. Mass withdrawals of funds by panicked depositors, as occurred
last year in Russia and Indonesia, quickly leads to economic depression.
By cutting interest rates three times in the fall of 1998 the Federal
Reserve restored confidence in financial institutions and prevented
a global economic meltdown.
With the financial crisis in Asia receding, the price of oil rising,
wage increases from coast to coast, and a building stock market bubble,
the Fed is once again focused on fighting inflation. Several weeks ago
the Fed raised interest rates and has indicated that more increases
may be in the offing. The one year reprieve from rate hikes has been
rescinded. Investors now face a vigilant Fed, determined to temper inflation.
Current Strategy
The application of our investment discipline indicates that stock prices
disconnected from underlying corporate fundamentals somewhat over a
year ago. We consider the market run over the past twelve months to
be speculative in nature and lacking a solid foundation. The shares
of the larger, well known companies are overvalued in our opinion. Internet
related stocks reached absurd valuations and have lost half their value
in recent months. There are pockets of value in smaller company shares,
but they may become even cheaper, moving down in tandem with the large
company and internet stocks.
Many of the positions we have purchased over the past ten years have
become fully valued in this bull market. While these stocks, i.e., IBM,
Citigroup, Texas Instruments, etc. started out as undervalued laggards
most have now turned into market leaders. Consequently we are in a profit
taking mode, scaling back on some of the bigger holdings. Our expectation
is that these stocks will be buyable again at lower prices or that we
will find different companies as undervalued as IBM was several years
ago.
We continue to find bonds appealing from an income and capital preservation
perspective. While stocks have outperformed bonds by a wide margin over
the past few years, there will be times when the reverse is true.
