“While nobody enjoys losing money, there’s nobody who escaped doing it.”
— Hugh McColl, Chairman, BankAmerica Corporation

When the Russian government defaulted on its debt obligations in July, it began the toppling of a long line of financial dominoes. Successive waves of selling by investment pools scrambling for liquidity fed the panic which swept world markets already wrestling with the Asian contagion. The well-publicized travails of the Long-Term Capital Management hedge fund served to showcase the fragility of the cracks arising from globalized liquidity pressures. The hubris of Long-Term’s partners was rivaled only by the greed and gullibility of its investors, bankers, and brokers. Together they facilitated a financial house of cards whose highly leveraged bets struck out.

Suddenly, in the face of growing financial turmoil, the admonitions of Alan Greenspan and Robert Rubin pushed l’affaire Lewinsky off the front pages. Investors began to flee from stocks and rush headlong into the safety of IOUs from the US Treasury. As a result, for the first time in thirty years, the yield on thirty-year US Treasury bonds dropped below 5%.

With the Dow Jones Industrial Average bouncing downward like a pinball in a financial arcade, yesterday’s irrational exuberance has tilted to irrational fear. Yet, just as the euphoria was misplaced, the worst fears of most investors are overdone and are probably already reflected in the prices of most stocks. Taking extreme steps at this point would be tantamount to closing the barn door after the horse has galloped away.

The unusually rewarding markets of the three-and-a-half years before this past quarter lulled many investors to sleep. They may have forgotten that markets also go down. In fact, in the twentieth century the Dow has undergone 52 corrections of more than 10%, fifteen of which exceeded 25%. While bear markets are no strangers to long-term investors, they have taken on a change in character. In recent years, bear markets and major corrections have tended to be compressed into shorter time periods than in previous years. Most recently, the downturns of 1987 and 1990 were severe in terms of price, but short in terms of duration. Bear markets of the long, grinding nature of 1973-74 are less likely to be repeated.

The almost instantaneous adjustment of stock prices to negative news results in rapid bear markets for individual stocks and, to some degree, the major indices like the Dow Jones Industrial Average. The key factors behind these severe and time-compressed price movements are the institutionalization of performance-driven money management and the communication of corporate and economic news to all participants on a simultaneous basis.

During the Great Crash of 1929, the Standard & Poor’s index of major stocks declined 45% from its earlier peak to Black Tuesday, October 29. Almost seven decades later, the violent sell-off of 1998 has been far less damaging, with the S&P 500 declining 28.4% from its 52-week high. Or has it? In fact, the decline of the average stock this past summer and early fall rivals the carnage of the 1929 crash. As the accompanying charts show, the recent decline and performance of the average stock on the New York Stock Exchange and the NASDAQ measures up against any bona fide bear market. Thus, while a literal handful of stocks (e.g., Cisco Systems, Dell, GE, Merck, and Microsoft) have buoyed the S&P 500, most stocks have been melting like Popsicles on hot asphalt. And it is not just the beleaguered mid- and small-cap stocks which have been bludgeoned. Recently, even such stellar blue-chips as BankAmerica, Disney, Gillette, Hilton, Kellogg, Merrill Lynch, and Motorola have fallen off the precipice as their valuations have been cut in half.

Thus, we may well have had our bear market in most stocks. For many, it began in April and only accelerated in July and August. For the larger-capitalization stocks, the slide began in July after Russia yelled nyet. In our opinion, the climactic selling days of August 31, September 30, October 1, and October 5 marked the bottom for most stocks. The question now is, “Where do we go from here?”

Will the meltdown continue? For most stocks, we think not. Near-term, the markets may well continue the abnormally high volatility of the last two months. But looking beyond the current turmoil, there are many reasons to believe that stock prices will return to a positive track.

As to the near term, stocks may struggle with obstacles directly or indirectly related to the impact of the global pressures placed on our markets:

• Stumbling efforts by Japan to address its economic problems and concomitant inertia among the G-7 countries continue to hamper a return to economic growth. A reversal of these trends would be a definite positive.
• Further exacerbating the economic uncertainties is the lingering Clinton presidential crisis, which is taking on a surreal life of its own with no quick resolution in sight.
• While most large-cap stocks have come down in price, a large number are still trading at fairly high levels, based on historical valuation measures.
• Weakening earnings—especially from multinational companies—will place downward pressure on prices. High valuations and weak earnings do not bode well for the remaining overvalued securities.
• Tax-loss selling by mutual funds and individuals will be especially pronounced as the year closes. Large capital gains were realized earlier in the year by most mutual funds and significant numbers of individuals. With mutual-fund performance slipping into negative territory, funds will not want to report large capital-gains distributions as their October reporting period draws to a close. Likewise, individuals will try and minimize capital-gains taxes through offsetting capital losses before year-end.
• Hedge funds may also continue to exert downward pressure on the markets. Many hedge funds only allow their investors to withdraw money at year-end. With large numbers of hedge funds incurring big losses, and the luster of hedge funds waning, many investors will be heading for the exits. Hedge funds will be forced to raise cash from whatever sources they can, including their more liquid large-cap holdings.

Yet these seasonal year-end factors should be balanced by some developing positives.

• The Federal Reserve has shifted from imitating Scrooge to playing Santa Claus with a bagful of goodies. True to form, the Alan Greenspan Fed will lower interest rates gradually, but lower they will. The continued low level of inflation, slowing US economy, deflationary winds from abroad, and a developing credit crunch have moved a little fear into the Fed’s computers. With the 30-year Treasury yielding 4.75% and 90-day T-bills at 4.12%, the markets are crying for lower rates and improved liquidity. They will get it. Short-term rates will be ratcheted downward. Money-market funds, a hiding place for investors, will drop their yields to levels meaningfully below 4% in 1999. With money-market and bond rates dramatically lower, stocks will begin to look increasingly attractive for investors holding trillions of dollars in money-market funds.
• Global leadership should begin to assert itself for lower interest rates and growth. Japan has, however reluctantly, taken the first steps toward banking reform and creative measures to extend credit to her Asian trading partners. Even the IMF is acknowledging that its ill-advised reforms pressed on emerging markets have done more harm than good in many cases. More concrete proposals and policies aimed at fostering growth from industrialized countries should be forthcoming. The end result of these shifts in emphasis will be a restoration of investor confidence, currency stabilization, and the forestalling of further deflationary pressures arising from a lack of demand. As confidence returns, demand will begin to rise, and the problems of excess capacity will lessen. Improving commodity prices will buttress the economies of a number of emerging markets.
• The growing federal-government surplus will result in less net issuance of US Treasury debt (a positive for interest rates), and also offer some flexibility for possible tax cuts and/or fiscal stimulus. These are potentially bullish factors.
• Earnings expectations, while too optimistic for the short to intermediate term, may begin to look brighter in the second half of 1999. The stocks of all but a handful of companies appear to be discounting a severe recession in 1999. As central banks move rates downward, the current liquidity crisis passes, and foreign markets stabilize, confidence should begin to return and economic activity should accelerate, even if only gradually. The markets will move from a state of panic and depression to one of hope and cautious optimism. Selling will be less pervasive, and financial assets will once again become attractive.
• The volatility and negative market sentiment of the past several weeks is characteristic of the behavior which is seen at the bottom of a market sell-off. Most of the damage to a large majority of stocks has already been done. A number of market indicators which are barometers of excessive optimism or pessimism are flashing bullish signals. As but one example, in recent weeks the CBOE equity put/call ratio has been registering its highest levels in history, rivaling and in some cases surpassing the ratios seen at the depths of the fall 1987 crash. Other measurements of market activity, such as upside and downside volume, new highs and lows, and the day-to-day volatility are registering the classic signs of seller exhaustion.
• Offsetting the runaway fear exhibited by emotional sellers and the forced liquidation of hedge funds is the massive buying by corporate insiders. Insider buying of stock has exploded off the charts in the last two months. There appears to be a decided disconnect between insiders and Wall Street about the prospects for the stock-price movement of a large number of companies. Insider buying has continued unabated, and in fact accelerated as the markets have declined. While insiders can sometimes be early, they are usually right about the direction of their stock prices. At present, they are obviously saying that their stocks are cheap.
• Stock buybacks are being announced with increasing frequency. Numerous corporations are signaling that their stocks have reached levels at which they should be bought. Coupled with the net reduction in corporate equity arising from corporate buybacks and a moribund new-issue market, the supply/demand dynamics of the market are quite positive.
• Merger-and-acquisition activity will begin to heat up and put a floor under stock prices. Leveraged-buyout funds have a potential buying power of $300 billion. Corporations also have cash coffers and bank credit lines with which they can acquire companies in addition to the traditional route of using their stock as currency.
  Thus, while there are many factors about which investors should be concerned, a bunker mentality ignores the opportunities for outstanding investment returns. After the October 1929 crash, when investors were jumping out of buildings, the S&P rose an incredible 47% over the following five months. The problems which developed in the 1930s were due to ill-advised trade legislation and the Federal Reserve reducing the money supply, the latter a mistake which will not be repeated.

Today, inflation is low, the Fed and other central banks are pressing the money accelerator, corporate balance sheets are generally in very good shape, technology continues to fuel growth, and job formation is still high. Corporate profits may slow their growth, but they are not going to collapse. With reasonable profit growth, rapidly declining interest rates, and strong cash flows and real savings, investors will be looking for a home for their funds. As money-market yields plummet, the supply of new issues dwindles, corporations buy back stock, leveraged buyouts retire even more stock, and government bond issuance declines, stock investing will take on a new meaning. Much of the mania and easy money surrounding investing will be discredited. Momentum or trend-following is fast losing adherents. High price-to-earnings stocks with slower earnings growth will become increasingly risky. On the other hand, and perhaps signaled by corporate insiders, a focus on value will grow increasingly important.

In looking back over the past few months, certain observations seem appropriate. The meteoric upward spiral in stock prices over the year and a half which ended in July was in many respects economically unjustified. Fueled in no small part by a worldwide liquidity boom, excessive leverage, and a flight to dollar-denominated assets, the peak in stock prices was the culmination of an international mania. Today, as the leverage balloon has been pricked, the scramble to raise cash has brought stock prices back to more reasonable levels of a year two ago. But beyond the simple adjustment to rational valuations, a large number of the stocks of many companies have plunged to price levels far below their value as economic enterprises. Yet it is the value of a business which over the long term will determine a rational price.

There is rarely a perfect time to invest or to hold fast. There is always something about which investors can worry. Today, there is no shortage of destabilizing influences on the investment horizon, and this is reflected in today’s bargain prices. It is out of such irrational fear and fire-sale pricing that subsequent recoveries are made.

Given the normalized historical rates of return on stocks and bonds, we remain of the opinion that the long-term economic fundamentals which affect interest rates, corporate profit growth, capital flows, and savings and investment favor investment in common stocks. The stock market should see new highs by no later than 2000. More importantly, in future quarters and years, a large number of those stocks which have been abandoned by index funds and momentum-driven institutional investors will eclipse the performance of yesterday’s high-flying stocks.

While we may not be out of the woods just yet, and the bearish gurus and headlines upset even the strongest of stomachs, the long-term future looks very good. If one reflects on the nature of investing, it is obvious that periods of excessive optimism and pessimism usually mark turning points in investment cycles. Today pessimism reigns supreme, and stock prices reflect today’s fears. Fear makes for great copy, but it does a great disservice to investors. A 4.75% 30-year bond may help you sleep better tonight, but it will probably not look as good over the next few years as large numbers of stocks which should climb the proverbial wall of worry to ever-higher peaks. The American economy will grow over the next few years, and along with it the value of those companies which participate in this growth.