Last Updated January 1998

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S THE BULL MARKET STILL INTACT, or will the Asian economic crisis adversely affect the U.S. markets? The answer is a resounding "Yes." To see why, let's sort through the conflicting static you've been hearing from the media and alleged "analysts". (Remember, these are the same guys who were apparently blindsided last autumn when the bottom fell out in Asia. Really makes you want to follow their advice, doesn't it?)

There's nothing going on here that a little common sense can't divine. The three things we'll focus on are inflation, interest rates, and equity markets. No, it isn't interesting, but it does give you a little direction when you're looking to invest…

Looking Back

Until October 1997, the stock market (as measured by the S & P 500) was reaching new highs. The last correction was in 1990. October's turbulence knocked it 10.8% off its earlier highs. Everyone blamed Asia. After all, Thai and Korean currencies were weak, Japan was in a proverbial recession, and the Hong Kong markets were being battered. But while the Asian economic problems really were serious, they were't the cause of the U.S. market's correction. At most, they were the immediate event that set it in motion.

To see why, imagine a line of dominos standing on end. (You remember, you used to do this when you were a kid.) If you push over the one at the far right of the line, they all fall; the one on the left is the last to come down. Now think of the Asian crisis as the domino on the far right and the U.S. equity markets as the one on the far left. Sure, one falling effects the other, but only if all the intermediate dominos are lined up in-between.

Just a few years ago when the Japanese stock market imploded and their economy went into recession, our markets continued on their merry way. The intermediate dominos weren't in place, so one event had very little effect on the other.

So what was different in October? Primarily the fact that this time, stocks were overvalued. By almost any yardstick, valuations were reaching new highs. The P/E ratio for the S & P was over 23X and the dividend yield was approaching 1.6%. All of this while corporate earnings growth was beginning to slow. The market was set for a fall; it just needed a catalyst. Asia provided it.

With that said though, don't think events in Asia won't continue to effect the U.S. economy. They will -- but not equally in all sectors. Some will actually benefit. Bonds are a good example.

Interest Rates

The correction in the U.S. equity markets also enhanced demand for bonds as investors needed a "safe" place to put funds from the sale of stocks. As with everything in economics, this is a supply and demand thing. With a fixed supply of bonds available, the increased demand drove up the price. Since bond yields move inversely with price, this increased demand also drove down the yields.

For about two years, the 30-year U.S. Treasury Bond had traded in a relatively tight range of 6.5% - 7.25%, but in late October, it was driven down to 6%. As demand continued to climb, the yield fell below 5.9% by late December. If you'd owned bonds prior to October, you'd have some nice profits. (By the way, if you'd followed our advice in modeling your portfolio, you would have owned some bonds in October. See "Should I Raise Cash?" in the Archives.)

Can yields stay this low? Probably not -- especially if there's no help from the Fed. With the 30-year bond below 6%, there's less than a half a point difference between it and the Federal Funds Rate, a benchmark short-term lending rate. Unless the Fed moves to lower this rate, there's little incentive for investors to tie up their money in anything longer than the shortest options.

Even if rates move back up a little, they probably won't have much of a negative effect on the economy, especially since they're starting at such a relatively low point. While they're likely to move back above 6%, they probably won't go far. Right now it looks like they'll spend most of 1998 in the 6% - 6.5% range.

The Fed will probably hold interest rates steady throughout most of the year. Their main concern is inflation so they won't be inclined to lower rates if they think it would over-stimulate the economy. In fact, their last move in early 1997 was a preemptive rate increase. They've had a pretty steady hand though out the current recovery, so unless the economy really bogs down, don't expect them to lower rates.

Inflation

Actually, you don't want either inflation or deflation. What you want, and what the Fed has achieved for the past several years, is price stability. With stable prices, there's no phantom premium of inflation or loss of value of deflation. Assets are priced by the market based on their intrinsic value. You can reasonably determine intrinsic value…but not the long-term premiums or discounts of inflation or deflation.

Fortunately, deflation probably won't be a real concern. While it is true that both the Consumer and Producer Price Indexes continue to surprise on the low side, this doesn't necessarily mean inflation is dead or deflation is around the corner. Even though we're not getting killed with runaway inflation, it is still rising at a pace of 2.75% - 3.25% per year.

Also, despite what you may hear on the evening news, the fact that gold recently fell below $300 and ounce, a 16-year low, does not mean deflation is imminent. Traditionally gold has been viewed as a hedge against inflation -- it went up in value when inflation was rising. If you believe this, then deflation should be an issue when the price of gold plummets.

But gold is an odd asset. It isn't really a commodity since its primary use is as a store of value. Commodities (like silver, oil, grain, etc.) have uses in the real world. Their prices are determined by the demand for them in the production of real goods. Real commodities have been mixed: Oil has been falling, silver has recently hit six-year highs, and farm products are basically flat. On average, commodity prices have been stable.

All of this is good on the inflation/deflation front. Without an unexpected commodity shortage (oil embargo anyone?) or a significant increase in wages (union contract negotiations due?), inflation can keep on its 2.75% - 3.25% pace through 1998. Stable prices and rates are great for the consumer, but not quite what the doctor ordered for the equity markets.

Equities

1. Rising Valuations
2. Falling Interest Rates
3. Increasing Corporate Earnings

Corporate earnings can improve with higher sales and revenues, or through lower costs. In the Nineties, many companies have taken the latter route by restructuring existing businesses, selling off unproductive ones, and even laying off employees. Most of these savings have already been realized. Improvements in technology have also assisted businesses in increasing efficiency. But you do get to a point where there really aren't many costs left to cut.

To keep growing earnings, businesses have to increase sales and revenues. In an inflationary environment, it's easy to increase revenues -- you just raise prices. But today, inflation is low and competition is tough, so it's quite difficult for businesses to raise prices. About the only thing to do then, is increase sales. You can increase sales by selling more units (or services) to the same market or by increasing your market share. This brings us back to Asia.

Sales, and therefore earnings, of domestic companies can be impacted by the turmoil in Asia. Not all companies will be affected, and some will (believe it or not) actually benefit. Obviously those that will be hurt the most will be those that depend on foreign sales. Coca-Cola's a good example, deriving over 70% of its sales from overseas. With its incredibly high valuation (over 40X earnings) any earnings disappointment will be tremendously magnified in Wall Street's treatment of its stock price...

U.S. companies that compete domestically with foreign businesses are also in for a rough ride. The auto industry is a good example. As the Japanese economy falls further and further into recession, the yen has depreciated significantly against the dollar. Due to the favorable exchange rate, sales of Japanese cars in this country translate into greater profits back in Japan. As a result, Japanese car manufacturers can hold prices steady (or even drop them slightly) and still maintain a competitive edge in the U.S. Domestic manufacturers can't raise prices so will have a difficult time increasing earnings.

To a certain extent, the strong dollar damps U.S. competitiveness not just in this country, but world-wide. For example, technology -- computers, software, and peripherals in particular -- has been a tremendous source of exports for the U.S. But again, when competing against countries with weaker currencies, domestic companies are at a disadvantage.

On the other hand, some businesses will benefit from the current situation. Those that have "outsourced" production to Asian countries will enjoy the benefits of reduced costs. On the sales side, companies that derive most or all of their sales domestically will be relatively safe (provided they don't have a lot of foreign competitors). Also, semi-monopolies (can you say cable companies?) or those with specific niche products (hello Microsoft) should be less effected.

A slower economy and/or greater competitiveness may also help those companies seeking an excuse for further charges or layoffs. While these are never popular and (should) reflect negatively on management, the Asian crisis provides a handy scapegoat for necessary actions. Presumably, increased earnings are the result of this cleansing.

So here's the bottom line: All else being equal, the economic conditions are in place for a good year in the equity markets. Inflation is low, interest rates are low, and the economy is expanding, albeit at a relatively low pace. By the same token, it's highly unlikely the market can attain a fourth consecutive year of 20%+ gains. Ripples from the Asian economies will have a negative impact on many domestic companies' earnings.

With this in mind, investors should seek companies that fall into the "least affected" category. These will tend to be those that do business domestically and have good market share. Most importantly, they will have quality management capable of growing earnings in a slow and competitive marketplace. In general, these will probably be small to mid-cap companies since they tend to have less international exposure than their large-cap brethren. They will also be companies that are fairly valued since overvalued companies will be severely punished when their earnings disappoint Wall Street…