Fortune Hunting

It’s never happened before. At no other time in history has the U.S. stock market racked up gains of better than 20 percent in three consecutive years. And the 120 percent cumulative advance of the S&P 500 since the end of 1994 is the best three-year return since a long but deceptive dead-cat bounce in the depths of the Depression. That’s not all that’s extraordinary about these fast-paced economic times. This March will mark the beginning of the eighth year in what could become, by the end of this year, the longest peacetime expansion on record.

Will it endure? Stress fractures can already been seen around the edges. Personal bankruptcies are at an all-time high, and the level of consumer debt ballooned $52 billion to $1.2 trillion last year. (Since the recession in 1991, consumer debt has increased a staggering 57 percent.) And retailers are at a loss to explain their third lackluster holiday selling season in a row, a phenomenon made all the more puzzling by sizzling job growth and percolating wage gains.

Despite the disappointing dollar volume of sales – after all, consumers have been conditioned to hold out for bargains on everything from laptops to Lamborghinis – corporate profits continue to edge higher, thanks to inflation’s extraordinarily quiescent behavior at every stage of the production process. Even the slight case of deflation besetting the economy now won’t dampen profits as long as overhead falls more than revenue declines. Interest rates keep heading lower, and that’s a big plus to the bottom line, since financing costs are the single largest outlay for most companies. Add to all this the strong likelihood of a budget surplus this year, a good chance for some sort of tax cut, and a palpable drop in crime and murder rates, and we’re talking about a society that makes the one depicted in Looking Backward, Edward Bellamy’s turn-of-the-last-century utopian novel, sound like an off-day at Esalen.

How can a nation that incessantly bemoans everything from the IRS to the heartbreak of psoriasis have achieved such an enviable list of economic accomplishments? Well, maybe it’s exactly because we worry so much. Thanks to the First Amendment and a citizenry with an insatiable appetite for controversy, just about everything gets a public vetting – from the latest whisper number of a hot stock to the leftward parabolic drift of the first phallus. Last year at this time, investors were fretting over what Fed chairman Alan Greenspan labeled the “irrational exuberance” of the stock market, a sobering judgment he delivered when the Dow Jones Industrial Average was around 6,400. This year, with the Dow trading some 1,500 points higher, it’s Asian contagion that’s got the swelling ranks of the moneyed class walking on eggs.

Disaster wasn’t supposed to strike Asia, a region that had strong growth, high savings, top-notch schools, an enviable degree of social order, and long-term economic planning. After all, weren’t its emerging economic powers – Malaysia, Indonesia, and Thailand – called tigers? But all that double-digit growth concealed a lot of cronyism, bribery, corruption, and a seemingly bottomless sinkhole of bad loans. Add to that shaky political structures in South Korea, Indonesia, and China, along with an ingrained aversion to any sort of banking reform, and you have the makings of a global liquidity crisis. As long as the maladies were confined to the lesser-developed countries, economists were satisfied that Asia’s financial ills would trim no more than 0.2 percent from world growth this year. But that was before a host of bankruptcies and a virtual free fall of the currency and equity markets in Japan and South Korea inspired a hasty rethink. Now the experts reckon that Asia’s economic woes will shave at least 0.5 percent from world growth, but the number keeps creeping higher with every new failure or scandal. The truth, of course, is anybody’s guess. Asia is not Mexico, a subservient client state with whom we share a 2,000-mile border. They do things differently over there; regulatory oversight is virtually nonexistent in Japan and Korea, where the banking system and equity markets are as entwined as braided bread.

So let’s get the bad news out of the way straight off. First of all, Asia will be in recession for most of the year. Since the entire region accounts for nearly 30 percent of total U.S. exports, that suggests the U.S. economy will stumble and profit margins erode as Asia buys less of the stuff we export and sells us the goods it produces at fire-sale prices. That could keep U.S. stocks under pressure for quite a spell. That, at least, is the conventional take on how the Asian contagion will spread to these shores.

“Our response – and this is where we part company with the rest of Wall Street – is that exports are a flimsy way to measure one country’s level of exposure with the world economy,” asserts Joe Quinlan, a senior international economist at Morgan Stanley. “A better measure is the sales that foreign-based U.S. multinationals make overseas which are not considered exports, and by this gauge, America’s commercial engagement with Asia is far less than many investors realize.”

Even though the U.S. has been the world leader in foreign direct investment for several decades, pouring close to $85 billion overseas last year, the bulk of the stash is not where most people think. “It’s not in Mexico, Brazil, or China or low-wage countries that are often accused of robbing jobs from American workers,” says Quinlan. “Rather, by an overwhelming majority, U.S. multinationals are more interested in gaining access to large, wealthy nations.” More than 70 percent of U.S. foreign investment is in the developed nations, with Europe accounting for half of all investment. Asia (including Japan) accounts for only around 17 percent of U.S. outflows.

Curiously enough, the mess Japan and Korea have gotten themselves into may do more to facilitate free trade and direct foreign investment than any other single event since Commodore Perry sailed into Tokyo harbor. For years, American companies have complained that it is too expensive to invest in Japan – well, now they can buy in on the cheap. And that’s apparently what they intend to do. Chase Manhattan, General Electric, General Motors, and J.P. Morgan are already looking at weakened companies in the region. Merrill Lynch plans to take over 50 branches of the failed Japanese brokerage firm Yamaichi Securities. About a dozen of the leading commercial and investment banks in the U.S. met with the Fed and Robert Rubin on December 29 with the aim of raising additional private financing for Korea and exploring business opportunities there. Even singer Michael Jackson has thrown his glove into the ring, negotiating to buy a ski resort from a bankrupt Korean underwear-maker.

U.S. firms that have been grumbling that Japan was cornering key growth markets like Vietnam should have a chance to move in while the Japanese try to dig themselves out of what amounts to a seven-year recession. When their bubble economy burst in 1989, instead of using the opportunity to clean up the banking system, Japan turned toward Southeast Asia with a vengeance, dumping loans at ridiculously thin profit margins in an attempt to win market share. By exporting capital to Southeast Asia in massive quantities, Japanese banks re-created the bubble economy that had burst at home and had sent them abroad in the first place. Instead of being a role model of long-term investing, Japan proved to be little more than a degenerate gambler, doubling down a losing bet at a different gaming table. Already, international creditors are demanding a special risk premium on loans to Japanese banks. Ironically, the much-criticized “short-term focus” of the U.S. style of capitalism creates the market discipline that keeps publicly owned companies on track.

The simple truth is that finance from Singapore to Japan is nowhere as efficient as it is in the U.S. Bank loans are equal to only about half of the U.S. GDP, according to a recent World Bank study. In Malaysia, bank loans equal 100 percent of the GDP, while Japanese bank loans amount to 150 percent of the GDP. The balance of U.S. funding comes from places like the corporate bond market, where prices can respond to a corporate misstep faster than you can say “Herbert Hoover Hashimoto.” It’s also ironic that another cause of Asia’s economic ills is the very success of the U.S. economy, which has driven the dollar higher and higher at the expense of currencies like the won, baht, ringgit, and rupiah.

While it has undoubtedly contributed to the shakiness of the U.S. stock market, the Asian mess is extending a bond-market rally that has taken long-term interest rates below 6 percent. The timing is perfect, because the Federal Reserve is unlikely to tighten anytime soon. Minutes of the November meeting of the Fed’s policy-making arm revealed that Asia’s liquidity crisis played a crucial role in keeping the central bank from raising domestic interest rates. And that’s a good thing. The many emerging economies linked to the dollar are also de facto linked to U.S. monetary policy. “A strong dollar has led to a contagion of competitive devaluations, which has exposed the frailty of many of the Asian economies,” says Madis Senner, a global money manager. “This contagion curbs growth and forces governments to pursue restrictive deflationary policies.” It also seems inevitable that Asia will be forced into observing some basic U.S. house rules like greater public disclosure of banking data and a more painstaking accounting of short-term business prospects.

Will you excuse me if I do not shed a tear? As Deutsche Morgan Grenfell chief economist Ed Yardeni notes, Asians have been world-class competitors in the world’s free markets for manufactured goods, but within their own borders they’ve stifled all competition. “They’ve had no trouble developing the technology needed to sustain export growth, but at home, they’ve made little progress in establishing the legal, accounting, and regulatory systems of capitalism necessary to sustain economic growth,” Yardeni asserts.

You don’t need an advanced degree to realize that in financial train wrecks of this magnitude, one country’s travail is another country’s winning lottery ticket. Asia’s financial crisis is already softening up the region’s longstanding aversion to foreign control. Under a long-delayed world-trade pact just finalized in Geneva, some 90 nations are expected to open their banking, insurance, and securities industries to foreign competition. Asian negotiators had opposed demands from the U.S. and Europe to substantially liberalize their financial markets. But financial crises have a way of transforming haughty opposition into fawning acquiescence. Asian countries now desperately need foreign financial firms to restructure their banking, brokerage, and insurance industries. The deal gives varying levels of ownership and operating rights to financial companies, whose interests will be protected by the rules of the World Trade Organization.

This ain’t no small beer. The pact covers some 95 percent of financial-services trade and means that big banks and insurers in the U.S. and Europe will get freer access to developing markets around the world. Indonesia, for example, agreed that foreign insurers can own 100 percent stakes in insurance companies. That compares with a 1995 offer of minority stakes in Indonesian insurance concerns.

So it seems that the U.S. now has an expanded role in the global arena. Robert Rubin and Alan Greenspan aren’t simply the Treasury secretary and chairman of the Federal Reserve; they’re also boss and underboss of a new world order.


As I mentioned at the start, the U.S. stock market is more or less in uncharted territory. Since this bull market began in 1982, stocks have averaged a total annualized return just north of 19 percent. What’s probably even more amazing is that there has been only one down year in the past sixteen, and that was in 1990, when Saddam invaded Kuwait. That means most folks are not going to expect another stellar performance from stocks this year. But put numerology and oddsmaking aside, and the economic fundamentals in the U.S. suggest another year of double-digit stock-market gains.

The U.S. is still the best investment haven on earth. You just can’t beat it for safety and growth. It wasn’t too long ago that we were one of the worst among developed countries in manufacturing productivity. Now we’re one of the best. But now is not the time to get fancy. In an environment as volatile as this one, investors are sure to pay up for the privilege of keeping what is euphemistically known as event risk to a minimum. So stay with proven blue chips, and have some cash on hand in case we’re favored with another rare opportunity like the 554-point plunge on October 27. Stay away from sectors likely to suffer earnings disappointments because of direct competition with Asian imports (semiconductors and auto parts), and concentrate on U.S. multinationals with the bulk of their foreign exposure in Europe. Raytheon Company; Great Lakes Chemical Corporation; Fortune Brands, Inc.; and General Mills, Inc., conduct virtually all of their overseas business in Europe.

You also could do worse than buying a handful of DJIA laggards. By that I mean those stocks in the Dow that offer the highest dividend yield. This may sound boring and uninspired, but hey, it works. For example, the Dow laggards suggested in this space last year (Philip Morris, J.P. Morgan, Chevron, General Motors, and AT&T) provided anyone who bought them with a total return of 27.8 percent in 1997. That compares with a 24.3 percent total return on the 30 stocks that make up the Dow.

Last year, this column also suggested trying a value approach to investing by buying proven companies with a low price-to-sales ratio, which can be determined by dividing a company’s stock price by the sales it generates per share. Although companies with a price-to-sales ratio of 1 to 1 or lower have consistently outperformed the market over ten-year cycles, the four companies (Chrysler, Fisher Scientific, Mobil, and IBM) I mentioned didn’t fare quite as well as the DJIA or S&P 500, netting 18.7 percent with dividends reinvested.

Again, don’t try to get too fancy. Small-capitalization issues, another sector that was recommended here, produced a total return of 22.2 percent – respectable, sure, but a far cry from the 33.4 percent that the S&P 500 netted with dividends reinvested. Because so many small investors have given up trying to beat the averages, parking their money in so-called index funds, the broad S&P 500 index currently outperforms more than 90 percent of professional money managers. So there’s a lot to be said for directing your hard-earned dollars into a plain-vanilla, no-load “index” fund and letting the earning power of the strongest economy on the planet make you rich.

Fortune Hunting