October 9, 1998
Dow Jones Average: 7732
S & P 500 Index: 959
Global Devaluation
After the dissolution of the Soviet Union the world seemed poised on
the threshold of a new era of growth, prosperity, and peace. The virtues
of capitalism and democracy were universally accepted, particularly
by those in former totalitarian states. Investors in developed nations
were seduced by the possibility of large returns in nations hungry for
capital. Well positioned corporations in Europe, the U.S., and Japan
salivated at the prospect of billions of new consumers. And workers
in developing nations were eager for better jobs and more disposable
income. This potentially symbiotic, profitable exchange of resources
and products was reflected in soaring stock markets worldwide.
We are now all painfully aware that something went wrong on this journey
to the promised land of global capitalism. For most of this decade emerging
nations did experience the upside of free market economics. But more
recently they found out that boom and bust cycles are inherent in the
capitalist economic model. The money that flowed so freely to the developing
countries from investors in Japan, Europe, and the U.S. was yanked out
as quickly as it went in. The outflow of capital wreaked havoc with
currencies, leading to devaluation, economic contraction and social
unrest.
Powerful trends tend to be both self-perpetuating and unsustainable.
The massive flow of investment dollars to Asian nations created high
rates of economic growth and high returns on capital. The profits made
by early investors inspired others to follow the same path. The surfeit
of cash pouring in led inevitably to overcapacity, financing of ridiculous
projects, and siphoning by corrupt officials. In many emerging nations
the financial, political, and legal structures were immature and easily
overwhelmed by rapid economic growth. As the positive, underlying growth
trends began to noticeably weaken investors panicked and pulled their
money out of emerging markets.
Economic policy makers are now pondering steps to stabilize the international
flow of capital without restricting investor freedom. There is fear
that a number of countries will return to state run economies as a result
of the recent catastrophic experience. Malaysia has already put restrictions
on removal of capital and Russia is thinking of returning to state ownership
of key industries. People living in depression era conditions are understandably
desperate for solutions. If capitalism is to prevail worldwide there
will probably need to be an international bank with enough resources
to offset outflows in times of panic. Unfortunately it is unlikely that
such a major economic initiative will be successfully promoted by a
President facing impeachment.
Current Strategy
The breakdown in stock prices that we had been expecting hit with tidal
wave force in the past few months. Even we have been surprised by the
depth of the decline. In many respects the current decline has been worse
than the 1987 crash. The average stock has lost over 50 percent of its
peak value. Many smaller companies have shed 80 to 90 percent of their
former prices. The decline has already spanned several months, relentlessly
grinding away at investor psychology. In contrast, the crash of 1987 inflicted
more uniform damage of about 35 percent over the course of one week.
Cash reserves and cash equivalents such as bonds are the key to riding
out and profiting from a bear market. Declining stock prices represent
a potential bonanza for those with cash, because it takes far less money
to buy a sizable position in a depressed stock. Subsequent gains can
be impressive, when and if the stock returns to a more normal price
level.
We have taken action over the past year to build our client cash reserve
position. Some sales were made in December and January with many more
occurring in recent months. We sold a portion of certain holdings and
complete positions in other cases. The sales were generally close to
the peak price attained by the stocks during the past year. With few
exceptions the positions we have retained represent core holdings in
important industry sectors.
Stock prices are much more attractive than they have been in years
assuming that earnings hold up. If the recession currently gripping
Japan and the developing nations spreads to the U.S. and Europe, most
stocks will slide further. Since no one can be sure if a recession will
materialize, it is wise to be in companies that are financially strong
enough to weather difficult times.
