What we are dealing with in the markets is a situation where five key elements in the global investment landscape are coming together in a highly interconnected way—creating these huge imbalances that must be resolved. . . . Japan’s deflation and systemic crisis, the spreading emerging-markets debt crisis, the profit margin squeeze on the U.S. corporate sector, as well as the growing and unsustainable imbalance between Asia’s deflating assets and the inflation of financial assets in the West. What this confluence of events will produce . . . is a major reversal of policy.
— Felix Zulauf, Zulauf Asset Management

“It’s déjà vu all over again.” Yogi Berra’s entertaining malapropism certainly fits the latest round of the Asian crisis. Whatever the causes of the morass in which the Asian economies and markets find themselves, its impact on the United States and other world markets has recently become more burdensome.

The failure of Japan to take effective measures to stimulate its economy, the world’s second largest, has led to renewed and quite legitimate fears that it will drag the world ever deeper into its economic whirlpool. The turbulence in domestic and international currency and financial markets over the last several weeks may well signal an inflection point for world economies.

Over the past seven years, world trade has accounted for almost 50% of global economic growth, to which the developing countries have contributed the most. As Japan is their largest trading partner, the Japanese denouement has finally overtaken Asia and the developing countries. Japan is the key to loosening the financial gridlock which shackles Asia and the emerging markets and which is belatedly being recognized by many observers as undermining the economic growth of the United States and Europe as well.

In September 1985, one U.S. dollar was exchangeable for 240 yen. The Plaza Accord, fashioned that same month by world economic leaders, was aimed at weakening the dollar, strengthening the yen, and reducing the massive US trade deficit with Japan. By February 1987, the exchange rate was ¥140:US$1, and the Louvre Accord sought to stabilize the situation. As recent history has shown, the Louvre “fix” did not hold. The dollar underwent a decline for several years, reaching a low of ¥79.75:US$1 in April 1995. From there, it has experienced a multi-year recovery which has accelerated in recent months; the exchange rate at the end of June was ¥138.93:US$1.

The Plaza Accord marked a turning point for the dollar/yen relationship. It gave rise to a major Japanese shift of low-value-added manufacturing to the nations of southeast Asia. An investment boom followed, with higher incomes and rising expectations throughout southeast Asia providing a positive impact on international trade for several years. But present Japanese exchange rates and a failing economy are causing severe imbalances in Japan and throughout the world, and wreaking havoc in Asia. Today, the world needs another, more effective set of economic and monetary policy agreements to right Japan.

Unfortunately for Japan and the rest of Asia, the Asian boom was not accompanied by a corresponding reform of the structure of banking, taxation and fiscal policy, and trade. The events leading up to today’s Asian crisis have been well chronicled. The result is a Japan which is no longer the engine of growth in Asia, but a leaden weight. With its debilitated banking system, straitjacket taxation, and weakened currency, Japan is reversing the Asian growth pattern of prior years. Japan is no longer a source of significant new credit to its trading partners, and perversely, its bankers, desperate to shore up their reserves, are calling in loans throughout the region. Japanese banks are contributing to the liquidity squeeze from which they are trying to escape. Final demand in Japan for raw materials and goods has also declined. Exports to Japan from its Asian trading partners have nose-dived. As a natural consequence of the yen’s plunge, Japanese exports have become more cost-competitive. Thus, further compounding the situation, Japanese manufacturers seeking outlets for their products are beginning to compete anew in markets which they had previously relinquished to many of their Asian trading partners. The decline of currencies, liquidity, demand, and prices throughout the region feeds on itself.

Further exacerbating the paralysis in Japan, the world is also witnessing tumult in Russia with its hapless ruble and collapsing stock market. And the dive in commodity prices (including oil) throughout the world, to varying degrees a byproduct of the currency and demand collapse, is placing more strain on the economies of emerging markets.

As the Asian crisis has worsened, hopes are rising that Japan will at last “do something.” The recent currency intervention by the United States came after the yen sagged and China made none-too-subtle threats that a protracted decline in the yen could lead to China devaluing the renmimbe. Such a development would prove chaotic for world currency and financial markets. President Clinton succumbed to the threat and dispatched his emissaries to Tokyo to prod the Japanese to take measures aimed at ending its game of financial roulette. But currency interventions can only forestall hard decision-making. With important elections in early July and a growing awareness on the part of both government and business leaders in Japan (some of whom have predicted a depression in the absence of constructive action), there is cautious optimism that the deflationary spiral can be arrested. Whatever steps are taken by Japan, China, and other nations, certain possibilities will directly and indirectly affect markets around the world.

In essence, world markets have been walking a tightrope over the twin evils of deflation and inflation. If the trend toward deflation were to accelerate, the global consequences could be devastating, both economically and politically. However, we think the odds of a deflationary descent of long duration are relatively low. More likely will be a gradual reflation (an increase in price levels and an expansion of credit) leading to greater global demand for goods and services, the spark of which will come from a reversal of the credit and currency implosion in Japan and Asia.

Despite incredibly low nominal interest rates in Japan, the real cost of money in Japan is too high as deflation creates incentives to save, not to spend and invest. Asia must grow its way out of its problems. At this stage, high real interest rates aimed at defending currencies are counterproductive. The International Monetary Fund should take note.

We think Japan will, sooner or later (hopefully sooner), reduce income and consumption taxes, bite the bullet on recognizing bad loans and letting a number of banks and corporations fail, and allow its domestic asset prices to fall. Such steps would foster a final cleansing of the excesses of the Japanese system and bring its bust closer to an end. Like the phoenix, Japan will be positioned to rise from its ashes. These measures would also lay the groundwork for Japanese investments to offer more attractive rates of return, and, after a possible period of further yen weakness, shift the demand for currency from the dollar to the yen as well. Funds which flowed out of Japan and Asia will begin to return as the prospect of recovery takes hold. The bloodletting will end, and the long convalescence can start.

If such a scenario were to unfold, what are some of the possible implications for financial markets? One market veteran, John Neff, the esteemed and retired manager of a major mutual fund, offers some thought-provoking observations and opines that we may be at a point when certain “myths” of the US market are being dispelled. He believes the end is in sight for such myths as “Inflation is dead. Long-term bond rates are going down. Overwhelmingly positive cash flow into equities is a given. Profits continue [to be] favorable.” Certainly, these myths reflect much of current conventional wisdom.

The news on inflation in the United States has been very good. But commodity deflation and lower import prices, outgrowths of weak global demand and surplus production due primarily to the Asian crisis, have masked developing pressures on the wage side. Services comprise 58% of the CPI. With low unemployment, wage costs (the largest component of services) are creeping upward. So too are such items as housing, medical expenses, and tuition. If a bottoming process takes hold, global demand for commodities and goods should turn upward, with a concomitant push on prices. Coupling domestic cost pressures with renewed global demand could result in inflation which would not be as benign as it has been in recent months.

If inflation goes up, interest rates probably will too. The rise may not be to levels as dramatic as those of the ‘80s and early ‘90s; rather than a thirty-year US Treasury bond yielding 5%, as many predict, the yield may move up to 6.5% or so from a mid-year 5.62%. For bond investors, this would spell downward prices; for stock investors, it would put downward pressure on P/Es and prices.

Perhaps the most problematic issue for investors today is the prospect for corporate profits. Almost as important, if a profit slowdown occurs, will it impact certain types of companies more than others? It is around these issues that the inflection points of the markets will be most pronounced.

Over the last several years, major corporations have experienced explosive earnings growth, benefiting from restructuring, productivity improvements,technological advances, and rising sales. But the long period of significant cost reductions, operational improvements, and increasing profit margins appears to be coming to an end in terms of their rate of change. The global slowdown is further limiting pricing power and revenue growth, thus putting a larger dent in the profits of multinational companies. Earnings growth for the S&P 500, a proxy for large companies (those with a market capitalization of more than $5 billion), has slowed to 6.5%, versus about 16% annually over the past five years.

A corollary to strong earnings growth has been the additional impetus given to large-cap stocks by index funds and a stronger dollar. Index funds and their first cousins, the closet indexers, have provided ever-growing amounts of money funneled into the market giants. As long as the money rolls in, the funds keep buying the same stocks—regardless of fundamentals and valuations.

Less publicized, but of increasing importance in recent quarters, has been the influx of funds into bonds and stocks as a result of overseas recessions and a strong dollar. US investors have fled most international markets (except Europe). Foreign investors have viewed the United States and Europe (which is benefiting from corporate restructuring and a move to an integrated economy) as safe havens with good economic prospects, particularly when compared to their own sliding currencies and bleak economies. With a strong dollar, foreign investors get a double-barreled effect: by investing in US stocks, they benefit from a strong dollar vis-à-vis their currency, and they get capital appreciation as well.

The first-quarter 1998 Federal Reserve Flow of Funds reveals a surge of foreign purchases of US equities and a dramatic slowdown of foreign stock purchases by US investors. US investment in foreign stocks is running at the slowest annual rate (approximately $9 billion) since 1990, and is one of the major factors behind the drying up of liquidity and demand in emerging markets. At the same time, foreign buying of US stocks has exploded, running at a $116 billion annual rate. This compares to a $227 billion annual rate of domestic stock purchases for US mutual funds and a $31 billion annual rate for state and local retirement funds. Foreigners now own 7.5% of the market value of US stocks, slightly surpassing the 7.2% high of 1986-87.

This issue of foreign ownership should not be overlooked, as it may have also contributed to a widening gap of valuation and relative performance between large-cap stocks and mid- and small-cap stocks. Not surprisingly, foreigners have a strong bias toward the largest corporations. If the dynamics of foreign demand are reversed, it could compound the potential problem of overvaluation for a number of large-cap stocks. Will the foreign love affair with US stocks continue if global investors regain confidence in other markets (most notably Asia and the emerging markets), or if the dollar weakens?

The huge divergence between the performance of large-cap stocks and that of mid- and small-cap stocks is the most significant characteristic of the US financial markets at mid-year. For the six months ended June 30, the S&P 500 return was 17.7%, whereas the Russell 2000 was up a mere 5.3%. May was particularly painful as the S&P MidCap Index dropped 4.6%, the S&P SmallCap Index fell 5.4%, and the S&P 500 declined only 1.9%. Also interesting is the fact that although strong performance has been concentrated in the large-cap names, the superior results are confined to an astonishingly small group of stocks in the large-cap universe. Only seven stocks—1.4% of the S&P 500—have generated 33% of the return in the S&P 500 for the first six months of the year.

There is no debating that mid- and small-cap companies have reported, on average, very good earnings for the first half of 1998, yet both continue to suffer from a liquidity malaise keeping the segment from performing better. For example, the profits for more than 900 small-cap companies tracked by Prudential Securities were up 19.8% through the first half of 1998; by comparison, large-cap profit growth was up a mere 5.1%. The last time the spread in profit growth between small-caps and large-caps was this wide was back in the first quarter of 1992. But the markets seem reluctant to reward such favorable results. Instead, the focus is on liquidity and premium P/E ratios placed on projected earnings, a phenomenon which continues to drive the outperformance of large-cap stocks.

The dichotomy in today’s US market recently sparked a chilling analysis by Scott Black, an exasperated small-cap money manager:

The operating earnings of the [S&P 500] are $47.50, so that’s a 23 multiple; 4.5 times book. You have roughly a 1.3% dividend yield. I think the market is vastly overpriced. I would actually say more overpriced than in ’87. What it reminds me of is the Nifty Fifty era – 1973.

Also, some of the blue chips, companies like Coke, [are] selling at over 40 multiples. It used to be the rule of thumb that you shouldn’t have a . . . P/E on a growth stock [higher] than its growth rate. Many of these [blue chips] are only 12% - 13% growers. So this reminds me of Avon, Xerox, Litton and Polaroid—before they got bombed in ’73. Ultimately, 12% - 15% growth doesn’t hold up 50 multiples. For the stock market as a whole, corporate profits were up only 2.9% in the first quarter, [and] are probably slowing again. I don’t understand how you get a 23 market P/E with no growth in profits.

Interestingly, Black proceeds to extol the virtues of a number of stocks which he considers good investments. But they are definitely not the richly priced large-cap stocks chased by the liquidity-obsessed institutional and mutual-fund managers and foreign investors.

The disparity of valuations is also illustrated by the P/E of the New Horizon Fund, a well-known mutual fund which is considered a proxy for small-cap growth stocks. The New Horizon P/E relative to that of the S&P 500 has declined below 1.0 only twice in the past 38 years. In mid-June, it was 1.02. When small-caps peaked in 1983, it hit 2.2.

Nevertheless, not all large-cap companies are overvalued, and a number of mid- and small-cap stocks are cheap for good reason. Our research process and stock-selection methodology, which are based on the discipline of private-market value, enable us to unearth potential opportunities from among all market capitalizations, a major advantage for our clients. We currently own and are buying a select number of large-caps in our client accounts, and we continue to look for value among all capitalizations. However, presently we are finding many more intrinsically undervalued stocks among mid-cap securities. Our focus remains on value, and others can chase those highly overvalued securities which are propelled upward by factors which, while very real at present, portend potential trouble in the future.

The world stage is set for a major international policy change. We do not know what it will be, but we suspect that politicians and central bankers will opt for growth. Major economic policy shifts will be aimed at stimulating domestic demand within Japan and raising demand through international trade for the commodities, goods, and services of emerging markets.

If the US economy begins to change, as it appears to be doing, the fortunes of many overvalued large-cap stocks may become less rosy. Presently, deflationary pressure from abroad is facing off with inflationary pressure in the United States. Although the two balance one another at the present, we think efforts to reflate abroad will tilt the scales toward moderately rising inflation, higher interest rates, a weaker dollar (eventually), and slower large-cap profit growth. Should this develop, foreign and domestic investors may exit these large-cap stocks.

Who are some of the beneficiaries of a change in foreign and domestic economic dynamics? Among others, companies which can increase their top-line growth faster than costs rise should prosper. Such an environment typically benefits those mid- and small-cap companies which have greater pricing power and flexibility than large-caps in an inflationary period. The stocks of companies with interests in real assets (such as real estate, metals, and energy investments) should begin to provide a greater return to investors. Energy has been punished over the past several months, and oil prices are at decade-low levels. However, energy and energy-related investments should recover as the world begins to reflate to avoid the abyss of global deflation.

Another trend which should continue is a high level of merger-and-acquisition activity. Banking, brokerage, broadcasting, energy, health care, technology, telecommunications, retailing, and many other industries should witness continuing consolidation. Many undervalued companies whose stocks have languished as money managers bid up today’s expensive darlings will receive attractive offers to be acquired at premium prices.

The dramatic events of the past few months are planting the seeds for improvement abroad. As the stranglehold arising from the collapse of former speculative excesses abroad is eliminated, and as Japan, Asia, and the emerging markets begin the process of recovery (however painful), the light at the end of the tunnel will no longer look like an oncoming train. Rather, it will shed light on opportunities for those investors who are properly positioned and focused on economic value (as opposed to the false sirens of unsustainable profit growth and liquidity). For the policy makers, it is decision time. As Yogi said, “When you come to a fork in the road, take it.”