When written in Chinese, the word crisis is composed of two characters. One represents danger, and the other represents opportunity.
— John F. Kennedy

At the close of 1997, consensus thinking about prospects for the US equity markets in 1998 was somewhat downbeat. After three years of roughly 20% returns on the major averages, most observers looked for a regression to the mean, although some optimists looked for the bull market to continue to record highs. But as Father Time yielded to the new year, it was obvious both camps were correct. Indeed, the major indices set new yearly records. At the same time, most stocks (and most institutional money managers) badly lagged what is popularly perceived as “the market.”

Indeed, a look back at 1998 will provide economists and investors with memories of a turbulent year. Most common stocks’ price patterns were reasonably positive through April; at that point, most stocks began to suffer a major bear market. A burst of energy in July caused a literal handful of stocks to propel the major indices to new highs. But with international pressures arising from Russia’s debt default and dangerously overextended hedge funds, the bottom for most stocks opened like a trapdoor. Investors sold first and asked questions later.

As financial meltdown loomed larger, the Federal Reserve and other central banks turned on the money spigot. After a series of violent market sell-offs culminating on October 8, investors began to return. But their appetites were appeased primarily by high-growth issues, regardless of valuation, along with a corresponding flood of money and speculative juices which flowed into all things directly or remotely connected with the Internet.

As the curtain fell on 1998, investors were asking if a new era were dawning. There was no shortage of mind-boggling statistics for those who shouted, “Yes!” For example, the average price/earnings ratio of the S&P 500 was 26.1 times 1999 estimates, an historical high. The four largest companies in the S&P 500 (Microsoft, General Electric, Intel, and Wal-Mart) had a combined market value greater than all the two thousand companies in the Russell 2000 (the most widely used small-cap index). Yahoo, an Internet darling, sported a market cap twice the size of that of Sears Roebuck, and about equal to that of Boeing, even though generating a fraction of their revenues.

As 1999 unfolds, the predictions for the next twelve months are reminiscent of the generally cautious outlook uttered a year ago, albeit accompanied by a minority of gurus who are very bullish. Will the markets again disconnect from consensus thinking and propel stocks and bonds ever higher yet again? Perhaps if corporate America were to change its moniker from Incorporated or Company to dot-com, the markets could surely double and triple in no time at all.

There is little disagreement that the popular averages—as opposed to the price of the average stock—are at rarefied levels. And most of the “old hands” of Wall Street shake their heads in disbelief at the frenzy surrounding Internet stocks. Can what some call a mania continue? Of course it can. Will it? It is quite possible, even if at a somewhat subdued pace. It may not be until later in 1999 that the explosion in large-cap growth stocks begins to slow on both an absolute and a relative basis. The hot-air Internet balloon may experience a puncture hole or two somewhat earlier.

We were recently reminded of a Peanuts cartoon in which Charlie Brown and Lucy are sitting at the table. Charlie, ever the philosopher, attempts to cheer a very disconsolate Lucy: “Don’t worry, Lucy, life has its ups and downs.” Unmoved, Lucy snaps back, “I don’t want any downs; I just want ups, ups, and more ups!”

Lucy could have been looking at her mutual-fund report for last year, for which Barron’s reported that 90% of equity funds had underperformed the S&P 500, most by a significant margin. Investor expectations seem to be rising ahead of economic reality. A recent poll revealed that investors expect ten-year average stock returns to be close to 20%. To say the least, that is an irrational expectation.

We all hear about how well the market is (or is not) doing. The ubiquity of financial “news” today is deafening, if not downright maddening. The table tells more about last year’s “markets” than most commentators said during the whole year. Yes, the S&P 500 and the Dow had record years. But only fourteen stocks accounted for 50% of the performance of the S&P in 1998, and 76% of all stocks trailed it by 15% or more. The average investor and the real-world portfolio manager do not typically invest funds in such a concentrated fashion. On an unweighted basis, the price performance of stocks was anything but bullish.

Thus, the apparent rise in stock prices during this turbulent year was not as widespread as it seemed. Of all common stocks on the New York Stock Exchange and the NASDAQ (over-the-counter) trading on the last days of both 1997 and 1998, the performance disparity was striking. For the year, 945 NYSE stocks were up, while 1,429 were down. On the over-the-counter market, 1,261 were up, while 2,360 were down.

While the number of stocks participating in the market’s advance in recent years has been narrowing, last year’s performance was astounding. A mere four stocks—0.8% of the S&P 500 Index—accounted for 25% of its move in 1998, and just a handful, 33—or 6.6% of the Index—made up 75%. Even more intriguing are the valuations of this group of 33. The average price/earnings ratio, based on 1998 estimates, is 44.1 times, while the average price/book value ratio is a hefty 14.3 times. That equals a price/earnings ratio for the group 170% greater than that of the S&P 500—which itself is currently at record levels—and a price/book value ratio 220% higher than that of the Index.

There has been much discussion over the last few years about the disparity in valuation between large-cap stocks and mid- and smaller-cap stocks. Certainly many of the arguments, based on a pure historical and economic analysis of valuation benchmarks, are indeed valid. Yet what seems to have been demonstrated during the liquidity crisis of last summer and fall is that in today’s global markets and instantaneous online trading, investors have been more than willing to place a high premium on liquidity and perceived safety. This should come as no surprise. In periods of financial stress, the desire to avoid losing one’s money takes a major priority over the prospect of making money. And certainly, Microsoft for example (which trades at 63 times trailing twelve-month earnings) is a sound company. The question facing investors is, “Are richly priced yet financially sound companies really the ‘safe’ investments they are perceived?”

What we have witnessed over the past several months is an inflation in financial assets—as much of the liquidity provided by the Federal Reserve and other central bankers finds its way into the markets, but not productive economic activity. Among the major beneficiaries of this liquidity have been the US Treasury market and large-cap growth stocks. At the same time, the world has witnessed a deflation of commodity-based assets such as industrial commodities and raw materials like oil, copper, tin, iron ore, et cetera. The global disinflation traces many of its problems to the tremendous growth of capacity around the world. One of the dilemmas for the Fed and other central banks is how to stimulate the world economies in the face of too many raw materials, goods, and services chasing too little demand. There is an excess of almost every commodity, manufacturing plant, and equipment used in economic activity. The record number of mergers occurring over the past few quarters is driven in part by the need to reduce capacity. Thus, if a paper producer buys another paper company, it will in all probability close some plants in an effort to stabilize prices for its remaining production.

The problem of excess capacity—whether in autos, chemicals, steel, paper, or DRAM chips—weighs heavily on the ability of companies to raise prices in a slow-growth global environment. As wage pressures accelerate and pricing power is curtailed, and as it becomes more and more difficult for companies to cut additional costs, profit margins come under pressure. If profit margins decline, corporate earnings will be far from robust. One of the ironic discrepancies being played out on Wall Street is the “what, me worry?” attitude of industry analysts in the brokerage community calling for 15% to 20% earnings growth of their individual companies, contrasted with the far less rosy expectations of the top-down strategists from the same brokerage firms. Both cannot be right.

Thus, earnings power may serve as one of the key factors in the performance of investments in 1999. The focus on predictable growth will undoubtedly continue. Against the background of an accommodating Fed, the premium paid for growth will stay high. Although “cheap,” many value-oriented cyclicals will be subject to a “show-me” attitude. In the face of continued excess capacity and sub-par earnings growth, there will be little incentive for aggressive money managers to load their portfolios with what they may perceive as “dead money.”

Recent Brazilian events, with their potential risk to Latin America and the United States, may worsen profitability problems for many multinational corporations. At the same time, analysts will have their eyes focused on Japan and the other Asian countries. The revolutionary introduction of the Euro will undoubtedly serve as a galvanizing event for European corporations to become more efficient and profitable. The various crosscurrents of the world’s economies have helped some recover, while others falter. The wave of currency devaluation may witness its final chapter in Latin America, although China remains a wild card. At some point, the injection of liquidity by the central banks and possible pro-growth fiscal and taxation policies should begin to rejuvenate economic activity. After a painful period of economic adjustment, growth should return to the world scene. Any sign of a pickup in the broad global economic outlook is important for two primary reasons. First, it could signal an end to commodity deflation and enhance the profit outlook for heavy industrial and commodity-related producers. Second, a recovering world economy would begin to dissipate many of the fears engendered by the liquidity crisis of this past summer and fall. If investors are more confident about economic prospects, they become somewhat less demanding of safety and growth premiums. As the relative growth rates of the limited number of market leaders changes vis-à-vis the vast stock universe, the money flows could shift to a larger universe of securities.

While a broadening of market leadership is likely to occur in 1999, investors should not delude themselves that all boats will rise with the tide. The last few years seem to have indicated that the institutionalization of the markets may well have resulted in a more permanent premium for size and perceived growth. With more and more money managed by institutions who are constantly under the gun to outperform, their relentless pursuit of the same stocks seems to signal a crying out of “If you can’t beat ‘em, join ‘em.” The liquidity bubble fuels an almost self-fulfilling process of chasing market leaders higher and higher.

Nevertheless, with so much money going into such a limited number of securities, it would pay investors to exercise some caution with an eye toward historical valuation. Trees do not grow to the sky.

Today, we see massive insider selling in Internet stocks and in many technology stocks. Perhaps we are showing our age, but we can recall other similar manias of the past. The bowling-stock frenzy of the 1960-61 period and the biotechnology blowoff of the early ‘90s are two of the more notable examples. The very real prospect of major changes in technology and retail distribution should not cause investors to overlook certain classic economic realities. Abnormally high rates of return are not generated for long periods of time before competition appears. With low barriers to entry, many Internet companies will be subject to intense competitive threats. The facile assumptions regarding the profitability of selling commodity consumer items or other services may soon hit a brick wall. Accompanying diminished profitability will be the inevitable and draconian adjustment of stock prices which will ultimately reflect realistic prospects of predictable cash flow (or lack thereof).

This year is likely to offer more of the same as 1998. Volatility will be the watchword. The casino aspect of trading stocks by momentum players and online traders will persist as long as credit is accommodating and liquidity is present. Growth companies which deliver should do well. Those which fail to produce will be taken out and shot. The disaster du jour will persist throughout the year. Aside from the handful of high-growth stocks which may well continue to attract big money and momentum players, what opportunities offer meaningful upside without a high-wire risk?

The table shows the average stock down considerably at the close of the year from its 52-week high. Aside from the severity of the decline is the appalling price action from among such a large number of issues. Of course, stocks usually go down because their economic prospects deteriorate. A large number of stocks from among different market cap sectors may also decline due to such factors as discussed, namely a flight to perceived safety and the penchant for liquidity demanded by huge capital pools. Against this background are intriguing opportunities for stock selection, despite the high levels of the S&P 500 and given the valuation disparities existing in the broader market. Undoubtedly there will be others as the year progresses.

Small- and mid-cap stocks seem more likely to enjoy brighter prospects. They are at historically low valuation points, their relative earnings should improve, and they may begin to receive new cash flows as their traditional supporters return from their flight to liquidity, perceived safety, and the pursuit of better relative performance.

Small- and mid-cap growth issues have only seen depressed valuations twice in the past forty years—1977 and 1990. Both were followed by multi-year outperformance. Combined with the S&P 500’s steady growth deceleration and less-than-robust earnings expectations, small-cap growth companies should deliver their best relative earnings growth since 1990-91.

Recent studies indicate that approximately 80% of small-cap mutual funds have shifted money to the large-cap sector. When the Federal Reserve raised interest rates in March 1997, investors shied away from smaller stocks. While they returned before October 1997, it was still a subpar year. As the global financial crisis burst on the scene in October 1997, risk premiums began to expand dramatically, reaching their peak at the time of the Long-Term Capital Management debacle last fall. In the face of the fear of global meltdown, small- and mid-cap stocks were tossed out the window.

As 1999 progresses, should short-term interest rates remain low and move lower and the fears of global financial turmoil recede, the prospect of improved earnings growth and historically low valuations could lead to a significant shift of money flows to other sectors of the capital markets. With so many investors having flocked to a mere handful of large-cap stocks, at some point who is left to buy them? Likewise, as regards the large number of stocks ravaged in the bear market of 1998 (yes, Virginia, it was a bear market for most stocks), who is left to sell them? From such dynamics of supply and demand do opportunities often present themselves.

The relative attractiveness of large-cap, or mid- and small-cap, stocks can be buttressed by arguments supporting either case. Over many years, we have succeeded with stocks of all market capitalizations. We want to make it quite clear that there are many values to be found among all market caps today, and we have a number of investments in large-cap stocks. However, on an historical basis, the disparity between valuations would seem to reflect a rather sizable premium being paid for size. And regardless of size, the price action of a stock is usually a barometer of the underlying company fundamentals and/or the relative attractiveness of a particular industry group or market-capitalization segment. As the figures cited above indicate, there were more downs than ups last year, and they included the large as well as the small. Is it possible that the upside-down pyramid of size and performance will even out? We suspect it will, but we also realize that it may take longer than most investors expect given the economic uncertainty in the air. In any event, the current imbalances in the market cannot be ignored.

So what do we take away from last year? The Business Valuation Approach—focusing on private-market value, low historical valuation, and growth at a reduced price—still works. One only need look at our investment in such industries as cable TV, telecommunications, financial services, pharmaceuticals, and many others to see the outstanding results that can be achieved. However, deteriorating fundamentals (as evidenced by a “Chinese water torture” price decline) which are unforeseen or rationalized can partially offset nice double- and triple-digit gains.

We will continue to rely on the discipline of business valuation which has served us so well for eighteen years. In a period in which Internet mania and sky-high valuations are becoming a siren song for Everyman, fundamental valuation would seem to be even more critical. Our good selections will far outweigh the bad over long periods of time. Nevertheless, we anticipate exercising a sharper knife for the inevitable “bad apple.”

In recent weeks, we have taken steps to reset the course of our portfolios. For accounts subject to taxation, we have offset the rather sizable capital gains realized during 1998 with losses from stocks whose fundamentals are somewhat problematic. By pruning and revitalizing portfolios with additional promising selections, the returns have already begun to improve. Not every quarter will be up, as Lucy might wish, but progress should be gradually higher, as it has been when viewed over the longer term.

Some economic benchmarks for 1999 are:

• Interest rates should remain low; short-term rates should move lower as 1999 progresses.
• Inflation should stay subdued, providing a bullish bias for stocks and bonds.
• Corporate profit growth will be positive, but not robust. Global economic growth should accelerate as the year unfolds. Asia will be far less of a drag on the world economies. Brazil and Latin America will delay the recovery.
• Despite the setback caused by the recent Brazilian crisis, equity risk premiums—the desire for “big and safe”—should decline further in 1999 from their panic peaks of last summer and fall. A declining risk premium fueled by money growth along with lower interest rates will funnel the excess financial liquidity into the stock market—especially those sectors remaining depressed from 1998.
• Companies continuing to deliver earnings should do well in the market. At the same time, value stocks and mid- and small-cap stocks, which offer attractive opportunities, should close the historically wide valuation disparity which presently exists, as market breadth spreads among more issues.
• The various stock-market indices have moved to new highs, and they should go higher in 1999. A move to 11,000 for the Dow would not be surprising.
• Most stocks have experienced a bear market, and in many cases virulent tax-loss selling. With each passing month, investor fears of a financial meltdown will be less of a deciding factor in their actions. There is no question that nominal long-term interest rates are low when viewed against the past few decades. However, real interest rates (i.e., adjusted for inflation) remain too high. Short-term rates have room to decline even further. Investors with large cash reserves in money-market mutual funds will become increasingly disenchanted with lower and lower returns as short-term rates trend downwards. Much of this money will be looking for a home in stocks and bonds. According to Donaldson, Lufkin & Jenrette, leveraged-buyout firms have the capacity to raise $300 billion in funds to finance acquisitions. Finally, many corporations will use their stock or growing free cash flow to finance acquisitions.

The gradual dissipation of fear, improving system-wide liquidity, the growing relative attractiveness of a larger universe of stocks, and a high level of merger-and-acquisition activity should broaden the number of participants in a new chapter of the bull market. Most investors have not had the majority of their money in only a handful of stocks. Very few portfolio managers have either. Thus, despite the euphoria surrounding the surging technology and Internet stocks, most investors are still licking their wounds from a savage bear market.

Over the coming months, the changing economic scene should witness more stocks returning to a positive price pattern. Sound stock selection, reasonable diversification, a greater vigilance to cut losses in the face of individual stock weakness, and an opportunistic approach capitalizing on the inevitable euphoria and fear of investors will be key to doing well in the future as we move toward the new millennium.