Last Updated March 1998

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O WHAT HAPPENED TO THIS ASIAN crisis thing? Is it over? As recently as last month investors were fretting over lower corporate earnings resulting from diminished foreign sales. At the same time, bonds were rallying to new highs as nervous investors sought a "safer" alternative to stocks. But now the tables have turned -- stocks are hitting new highs while bonds are flat to slightly down. Did the generally favorable fourth quarter earnings put an end to the Asian scare?

Unfortunately, the answer is "no". As with so many things, effects (particularly of foreign events) are not immediately felt. Instead, they take time to work their way through the economy; some moving as quickly as a ninety-year-old does in a heat wave. Recently the equity markets have overlooked this delay, you shouldn't.

Nowhere to Go

Bonds had a tremendous rally in December and January. By the end of 1997, the 30-year Treasury bond's yield had fallen to 5.92%. This trend continued in January, taking it to the 5.7% range. A lot of this rally was attributable to inflows from panicked equity investors as well as foreign investors seeking shelter from their domestic economies. All this increased demand for bonds drove prices up.

But as January turned into February, and February wore on, bonds inched back down. A bond's yield moves in the opposite direction of its price, so as prices slipped, yields edged back up. The 30-year Treasury was stuck in a relatively tight trading range of 5.85-5.95%. If the Asian crisis really is over, foreign investors will repatriate some of their cash and domestic investors will return to the equity markets -- not a good scenario for bonds.

Fortunately there are other factors at work here. While bonds were rallying in the fourth quarter of 1997, inflation (as measured by the Consumer Price Index) was decreasing from an annualized 2.2% to 1.7%. As the yield on the long bond came down, short rates remained stable. Even when the long end drifted back up, the difference between a ninety-day Treasury bill and the 30-year bond was less than a percentage point. Since the shape of the yield curve is representative of bond investors' prediction of inflation, you could pretty much conclude that future inflation was not perceived as an immediate problem. In fact, investor anxiety moved from fear of Fed rate increases to speculation of a potential decrease. Asia or no Asia, this is good for bonds.

Jump Starting in Fourth Gear

Subdued inflation, lower commodity prices, and falling interest rates usually indicate that conditions are ripe for the Fed to lower rates. With such a favorable backdrop, there's little danger that looser monetary policy will set off a bout of inflation. Even so, the Fed probably won't take any action, at least for the next several months.

Why? Well why should they? Presumably the primary purpose of monetary policy is to keep the economy on an even keel. If properly managed, it can take the edge off turbulent economic cycles. Tighter money drains liquidity and reins in inflationary pressures, while easing can help stimulate a sluggish economy. But presently, the economy is anything but sluggish. Despite Asia's woes, the U.S. economy continued its strong pace through the fourth quarter of 1997 and into January of this year. There's no need to jump-start an economy that's already cruising in fourth gear.

No, the Fed's too cautious for that. In fact, they're keeping an eye on the only potential fly in the ointment -- the tightening labor market. While Alan Greenspan has recently mentioned the dreaded "D"-word, he's more concerned about the specter of wage inflation. While the present economic conditions are favorable for lower rates, he'll probably keep that medicine in the bottle until the economy looks a little ill.

Higher Risk, Lower Expectations

Don't be fooled. This rally is more relief than prediction. Just as the Asian problem didn't appear overnight, it didn't disappear in a puff of fourth quarter earnings. The depth of the Asian crisis wasn't known until well into the fourth quarter at which time many companies had already booked the majority of their profits. The full impact of what's going on overseas won't be felt until the first few quarters of 1998. While lower interest rates and inflation will help damp its effects, the problem's still there.

You'll see it when earnings confession season begins again in mid-March. It's become routine that companies "preannounce" disappointing earnings in the last few weeks of the quarter. Analysts who overestimated earnings by underestimating Asia's drag will act surprised. You shouldn't be.

Remarkably, the stocks with the most foreign exposure are leading the market. The Dow Industrials and the Standard & Poors 500, both dominated by large, multinational companies, charged ahead in the first quarter of 1998. Both hit new highs in early February. By late February, the NASDAQ, dominated by large financial and technology companies, also hit a new high. But the Russell 2000, the measure of small caps, was still about 2% away from its previous record.

This looked a lot like the first six months of 1997 when investors flocked to large caps and left the smaller stocks behind. To a certain extent, this divergence was a result of investors' (mis)perceived notion of safety. After the shock of October 1997, investors venturing back into the market sought out the strong balance sheets and trading liquidity of large companies. But as the S&P edges closer to 24X earnings, there's little room for improvement in these valuations, and even less for mistakes. At these levels, any earnings disappointments will be severely punished. Given this, there's currently more risk here than in smaller stocks.

Comparatively, small stocks are much more reasonably valued. Most of their business is domestic, insulating them from foreign problems. Since investors already have low expectations for this group, any disappointments won't have a great impact and any positive surprises will be magnified. This is where the value investor should concentrate.

There's another factor making small caps attractive -- takeover potential. If individual investors can find value in this sector, so can other businesses. With tight labor markets and low inflation, it's hard for companies to increase profits by cutting staff or raising prices. They can, however, increase market share by purchasing smaller companies on the cheap. Any resulting staff reductions will further increase margins. While you wouldn't want to buy a stock strictly on its takeover potential (well you might, but that's as close to gambling as you could get without a lottery ticket), this possibility increases the benefit of seeking small, fairly valued, and well-managed companies.

Despite the generally favorable economic conditions, this year's equity returns will probably be more in line with the historical averages (~10%) than the 20%+ returns of 1995-1997. If this is true, large caps may have already seen the majority of their gains…