Interest Rates Rise – July 1999

July 25, 1999

Dow Jones Average: 10911
S & P 500 Index: 1357


Interest Rates Rise

The prime directives of the Federal Reserve Board are to insure the stability of the banking system, keep inflation in check, and promote economic growth. When the Fed is able to simultaneously accomplish all three objectives the financial markets are euphoric and the populace quite content. It is not easy for the Fed to maintain a delicate economic balance when the free enterprise system tends toward excess and speculation.

Inflation manifests itself in many ways. The Federal Reserve Board fights inflation in all its forms, because rapid price escalation in any area eventually leads to economic imbalance and boom-bust cycles. While rising prices for food, fuel, clothing, medicine, and other staples of life are a cause for alarm, inflation in real estate and financial assets is often a source of national pride. That view changes abruptly when property and stock prices reverse course leading to general economic malaise.

The Federal Reserve decided to move against financial asset inflation and incipient wage inflation in the summer of 1998, but was forced to change course by the global economic crisis. While controlling inflation and promoting growth are long term goals of the Fed, maintaining confidence in the banking system is the one objective that takes precedence over all others. Our entire economic system rests on the confidence and trust depositors have in the banks and related financial institutions that hold money. Mass withdrawals of funds by panicked depositors, as occurred last year in Russia and Indonesia, quickly leads to economic depression. By cutting interest rates three times in the fall of 1998 the Federal Reserve restored confidence in financial institutions and prevented a global economic meltdown.

With the financial crisis in Asia receding, the price of oil rising, wage increases from coast to coast, and a building stock market bubble, the Fed is once again focused on fighting inflation. Several weeks ago the Fed raised interest rates and has indicated that more increases may be in the offing. The one year reprieve from rate hikes has been rescinded. Investors now face a vigilant Fed, determined to temper inflation.


Current Strategy
The application of our investment discipline indicates that stock prices disconnected from underlying corporate fundamentals somewhat over a year ago. We consider the market run over the past twelve months to be speculative in nature and lacking a solid foundation. The shares of the larger, well known companies are overvalued in our opinion. Internet related stocks reached absurd valuations and have lost half their value in recent months. There are pockets of value in smaller company shares, but they may become even cheaper, moving down in tandem with the large company and internet stocks.

Many of the positions we have purchased over the past ten years have become fully valued in this bull market. While these stocks, i.e., IBM, Citigroup, Texas Instruments, etc. started out as undervalued laggards most have now turned into market leaders. Consequently we are in a profit taking mode, scaling back on some of the bigger holdings. Our expectation is that these stocks will be buyable again at lower prices or that we will find different companies as undervalued as IBM was several years ago.

We continue to find bonds appealing from an income and capital preservation perspective. While stocks have outperformed bonds by a wide margin over the past few years, there will be times when the reverse is true.

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