Global Devaluation – October 1998

October 9, 1998

Dow Jones Average: 7732
S & P 500 Index: 959


Global Devaluation

After the dissolution of the Soviet Union the world seemed poised on the threshold of a new era of growth, prosperity, and peace. The virtues of capitalism and democracy were universally accepted, particularly by those in former totalitarian states. Investors in developed nations were seduced by the possibility of large returns in nations hungry for capital. Well positioned corporations in Europe, the U.S., and Japan salivated at the prospect of billions of new consumers. And workers in developing nations were eager for better jobs and more disposable income. This potentially symbiotic, profitable exchange of resources and products was reflected in soaring stock markets worldwide.

We are now all painfully aware that something went wrong on this journey to the promised land of global capitalism. For most of this decade emerging nations did experience the upside of free market economics. But more recently they found out that boom and bust cycles are inherent in the capitalist economic model. The money that flowed so freely to the developing countries from investors in Japan, Europe, and the U.S. was yanked out as quickly as it went in. The outflow of capital wreaked havoc with currencies, leading to devaluation, economic contraction and social unrest.

Powerful trends tend to be both self-perpetuating and unsustainable. The massive flow of investment dollars to Asian nations created high rates of economic growth and high returns on capital. The profits made by early investors inspired others to follow the same path. The surfeit of cash pouring in led inevitably to overcapacity, financing of ridiculous projects, and siphoning by corrupt officials. In many emerging nations the financial, political, and legal structures were immature and easily overwhelmed by rapid economic growth. As the positive, underlying growth trends began to noticeably weaken investors panicked and pulled their money out of emerging markets.

Economic policy makers are now pondering steps to stabilize the international flow of capital without restricting investor freedom. There is fear that a number of countries will return to state run economies as a result of the recent catastrophic experience. Malaysia has already put restrictions on removal of capital and Russia is thinking of returning to state ownership of key industries. People living in depression era conditions are understandably desperate for solutions. If capitalism is to prevail worldwide there will probably need to be an international bank with enough resources to offset outflows in times of panic. Unfortunately it is unlikely that such a major economic initiative will be successfully promoted by a President facing impeachment.


Current Strategy

The breakdown in stock prices that we had been expecting hit with tidal wave force in the past few months. Even we have been surprised by the depth of the decline. In many respects the current decline has been worse than the 1987 crash. The average stock has lost over 50 percent of its peak value. Many smaller companies have shed 80 to 90 percent of their former prices. The decline has already spanned several months, relentlessly grinding away at investor psychology. In contrast, the crash of 1987 inflicted more uniform damage of about 35 percent over the course of one week.


Cash reserves and cash equivalents such as bonds are the key to riding out and profiting from a bear market. Declining stock prices represent a potential bonanza for those with cash, because it takes far less money to buy a sizable position in a depressed stock. Subsequent gains can be impressive, when and if the stock returns to a more normal price level.

We have taken action over the past year to build our client cash reserve position. Some sales were made in December and January with many more occurring in recent months. We sold a portion of certain holdings and complete positions in other cases. The sales were generally close to the peak price attained by the stocks during the past year. With few exceptions the positions we have retained represent core holdings in important industry sectors.

Stock prices are much more attractive than they have been in years assuming that earnings hold up. If the recession currently gripping Japan and the developing nations spreads to the U.S. and Europe, most stocks will slide further. Since no one can be sure if a recession will materialize, it is wise to be in companies that are financially strong enough to weather difficult times.

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