Basic Points

1999: Double Bubble

December 14, 1998

Recommended Asset Allocations American Portfolios

U.S Pension Fund Allocations
Domestic Equities Foreign Equities Domestic Bonds Foreign and Foreign-Pay-Bonds Cash 26 7 64 3 0

Change
unch unch unch unch unch

Bond Durations Years

Global U.S. Canada 4.25 6.25 5.0

Change
unch unch unch

Unless otherwise stated, charts are courtesy of Bloomberg.

Overview
It is that time again. Time to look backin anguishat last years forecasts, and time to look forward, in the hope that this time well get it right. (One sign of mental incompetence is trying the same experiment over and over, each time expecting a different result.) Last years Basic Points predicted that deflation would be the underlying trend in global capital markets. PPI would routinely be in negative territory, ultimately driving the GDP Deflator in much of the industrialized world into negative numbers. Bonds would outperform stocks. Deflation has been a potent force, although local cyclical inflationary pressures have obscured its impact in the US. Its beneficent effects on US consumerscheap gasoline, cheap goods in stores, and falling borrowing costsoverrode any investor concern that US corporate profitability was seriously endangered. In the summer, its corrosive effects on the financial system triggered a full-blown crisis. That roused the Fed and other central bankers into a bear hunt that has threatened the very existence of this endangered species. That bonds had a splendid year is scant consolation for US investors who followed our forecast. For an unprecedented fourth straight year, the S&P has delivered 20%+ returns. Bonds did outperform small-caps and did almost as well as the Dow Industrials. Stocks modestly outperformed bonds in Europe, while bonds were the winning asset class in Canada, Australia, and Japan. Ten years ago, Japanese stocks reached the bubble stage, prior to entering the longest deflationary bear market in history. Pumped up by a seemingly frantic Fed, US stocks are in a double bubble formation: inflated multiples of inflated earnings forecasts. Deflation will continue to be the big story in 1999, despite rapid money supply growth that has monetarists predicting inflations return. It will be a vintage year for whines, as companies report recurring non-recurring losses blamed (like Boeing) on the surprise that Asia and much of the Third World are in crisis. It will be the year in which bonds finally outperform stocks. Those two wily escape artistsBill Clinton and Saddam Husseinwill continue to flummox their foes for a while, but 1999 could be the year that at least one of them gets his comeuppance. Asian stocks, led by Japan, will outperform US and European stocks. We wish clients a Happy Hanukkah, a Merry Christmas, and a relatively uneventful New Year.

S&P Index since January 1, 1998

30-Year Treasury Yields since January 1, 1998

Basic Points
Donald G.M. Coxe (312) 461-5365/(416) 359-7019
Chairman and Chief Strategist, Harris Investment Management Inc. Chairman, Jones Heward Investments
e-mail: [Link]@[Link] Anne Stephaniuk, Publishing (416) 359-5083 e-mail: [Link]@[Link]

1999: Double Bubble

It has been the best of all possible worlds. Money supply is up big. Bonds are up big. Big-cap stocks are up even bigger. Real estate prices are up. The economy is up. Democrats are up. Whats down? Republicans, corporate profits and commodities. Republicans learned that the voters are willing to let Bill Clinton take credit for everything except what he actually did. Commodities have been sliding for years and corporate profits have been sliding for months, and investors have learned to regard them as mere distractions from the serious business of having fun in the Clinton bull market. Come back with me to that long-ago time, (now nearly lost in the mists of history) of October 1st 1998, when the Best Minds (including Bill Clinton, Robert Rubin, Michel Camdessus, and George Soros) were warning that the world faced its worst economic and financial crisis in fifty years. Global stock markets were trembling. There was widespread talk of recession, even of Global Depression. Major financial institutions shares were being savaged.

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But then, something wonderful happened. The crisis disappeared with magical speed. It was all a bad dream.

Lehman Bros. Holdings from June 1 to October 8, 1998

But then, something wonderful happened. The crisis disappeared with magical speed. It was all a bad dream. Lehman Bros. Holdings from October 8, 1998

What happened was that the Fed and other central bankers flooded the financial system with money. There had already been great liquidity sloshing around financial markets, but widespread abuse had wasted much of it, constricting its flow into some very important and suddenly very parched areas. Like a January rainstorm in Arizona that produces floods in the gullies, the joint action of the monetary gods was sudden

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and impressive, producing an explosion of efflorescence in its wake. US Money of Zero Maturity, Year/Year % change since January 1, 1998

The timing of the turnaround and the dazzling momentum on the trip back up looked as if St. Sylvester had arranged the whole event.

Chart courtesy of Nesbitt Burns Economics The markets turnaround and rally confirmed what many retail investors have felt all along: this bull market is driven not only by strong fundamentals (such as Q3 GDP growth of 3.8%), but by a supernatural force. Just when the Dow and the S&P were down 19.9% and threatening to break 20%, (which would, under the Accepted Rules, have confirmed a bear market), they turned and roared back, evenfor a brief intervalto new peaks. The timing of the turnaround and the dazzling momentum on the trip back up looked as if St. Sylvester had arranged the whole event. (As noted in the last issue, St. Sylvester should be the patron saint of the stock market: one of his miracles was raising a bull from the dead.) Once again, those who have argued that investors should never get out of stocks and should buy the dips have been vindicated in their profitable public adherence to the secular religion of the fin de siecle. With each new reaffirmation of the immortality of this bull, the population of public skeptics shrinks. Holding to
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Railing at the excesses in this market (which is becoming a secret, private activity, as sex used to be) misses the point...

principles that worked in earlier eras is life-threatening for strategists. When the Dow broke back through 9,000 a Nesbitt branch manager delivered the classic phrase to me: What have you done for me lately? Fair question.

The Fundamentalists Problem

It is the task of strategists to advise investors on what the markets are likely to do. A strategist who advises on the basis of what markets should do is interposing his or her ethical system on a basically amoral market. Railing at the excesses in this market (which is becoming a secret, private activity, as sex used to be) misses the point: the institutional investors task is generally understood to be the achievement of the highest possible returns against defined benchmarks. Thats why performance numbers are kept and thats why investors flock to the funds with the highest returns. Stock market fundamentalists have become to mutual fund organizations what Christian fundamentalists are to the Republican Party: backers of strategies that lose in the marketplace. What may still be useful is talking about risk-adjusted returns: this market may keep going higher, but it is surely the riskiest market since 1973. That doesnt mean it must crash. The hyperkinetic, hyperbolic Nifty Fifties joyride of 1971-73 might have lasted for years more had it not been for Watergate, the oil boycott, the Great Grain Robbery, and the sudden arrival of stagflation. The market didnt collapse just because the Nifty Fifty were absurdly overvalued. It was a gloriously extended venture in self-indulgence that required unanticipated external shocks to shatter its well-burnished image of invulnerability and inevitability. This market is even more self-indulgent, but the enthusiasts who reject valuation models have been right in their New Era convictions. Bad news is either minimized by the market or treated as good news. The party just keeps going on.

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Theres the story of the New Orleans apartment dweller whose infirm mother cannot sleep because of the loud music from a jazz group in the flat below. He goes down and knocks on the door. After repeated pounding, the door finally opens, revealing a saxophonist. Do you know theres an old lady sick upstairs? the son complains. No, man, I dont, but hum a few bars and Ill try is the cool reply. Laissez les bons temps rouler!, New Orleans motto, is the right strategy for this market. Who worries about hangovers?

Laissez les bons temps rouler!, New Orleans motto, is the right strategy for this market.

From the Exuberant Stage to the Bubble Stage

Alan Greenspan, Pontifex Maximus to this new secular religion, long ago fretted aloud that the stock market could be gripped by irrational exuberance. That is his most-quoted phrase, and it is now quoted not in a spirit of concern, but of irony. Basic Points was cautious about equities in 1997, but never bearish. I suggested that valuations were stretched, but not perilously, given my optimism that inflation and interest rates would fall deeper than the consensus expected. Real bear markets (baby bears, poppa bears and momma bears) had always followed rising inventories, rising inflation and rising interest rates. After the Asian crisis, I turned more cautious, rejecting the Streets consensus that this was merely a small flu bug in a group of mini-economies whose collective size was approximately that of Oklahoma. I turned outright bearish only when the Street was forecasting $49 for S&P earnings this year and $55 in 1999. Given the power of global deflationary forces at a time of full employment in the US, I saw no way those estimates could be achieved. Companies other than Microsoft would have little,

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Then, in the markets rocket run back to the heavens, the Internet stocks became The Big Story.

if any, pricing power, while their wage costs would be rising. Furthermore, I thought that the towering levels of investment and lending in Asia and the Third World put the global financial system at risk. Bonds were so obviously attractive that I saw little reason to stay heavily committed to equities as the world drifted toward a deflationary financial crisis. The crisis, I believed would be the Ides of March for the hubris in this imperious market. Now I feel like the seer who is told by Julius Caesar, The Ides of March have come, To which the seer replies, Ay, but not yet gone. That a 75 bp cut in the Funds rate (even when backed by nearuniversal rate cuts) could change the plot decisively strikes me as nave. The stock market is riskier now than when the Dow first scaled 9300. Heres why. 1. S&P earnings have been declining since June and will continue to fall for several quarters. That means the multiple is rising after an earnings peak, which is rather like raising ticket prices sharply for Titanic six months after the movie is released. At 1166, the S&P is trading at 27.1 times a reasonable (if a tad optimistic) forecast of $43.00 in 1999. The first full-blown mania in this long bull market has appeared. The Internet stocks had been merely a raffish sideshow when the market was moving majestically to 9300. Then, in the markets rocket run back to the heavens, the Internet stocks became The Big Story. Unlike past penny stock extravaganzas, these companies attain multi-billion-dollar capitalizations within days of their birth, long before they achieve earnings. (The only recorded faster growth to full stature was Athenas: she sprang full-formed from Zeuss brow after Hephaestus delivered the perfect headache remedy; he cured Zeuss

2.

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splitting headache by cleaving his forehead with an axe. Forehead-born, she became the Goddess of Wisdom, a quality not associated with phenomena such as) EBAY since September 24, 1998

The Fed has been forced into the uncomfortable role of punch-bowlreplenisher after the party has boiled out of control.

3.

The Fed has been forced into the uncomfortable role of punch-bowl-replenisher after the party has boiled out of control. First it organized the Long Term Capital bailout on terms beneficial to the Greenwich speculators (who would otherwise have had to sell to Warren Buffett at fire-sale prices). Then it cut rates in dramatic intraday fashion, turning collective financial penitence into the biggest booze-up in a generation. One for the road became Five for the road. In seeking to de-ice the lines in debt markets, the Fed (ably assisted by the rest of the worlds central bankers) flooded the system with cheap alcohol. The good news is that nobodys talking of a global financial crisis anymore. The really good news (as interpreted by the markets) is that the Fed is committed to propping up the stock market. Dont fight the Fed has become The Fed will make us all rich,risk-free. That is not the message the Fed wished to convey, but someone who supplies unlimited whiskey and car-keys to a teenage bash should not be surprised if the revelers behave injudiciously.

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In the maternity ward bed, his wife is saying, I dont care if he was born on a record day. Were not naming him Nasdaq!

Nasdaq Composite Index since August 15, 1998

(A recent Wall Street Journal cartoon shows a new father happily embracing his baby. In the maternity ward bed, his wife is saying, I dont care if he was born on a record day. Were not naming him Nasdaq!) 4. This huge surge in US liquidity comes at a time when US broad monetary aggregates were already growing rapidly. Money of Zero Maturity had been expanding at a 12.8% rate from end of October 1997 to September 28th, but its annualized growth from then is a quasi-Russian 22.8%. In that same period M-2 grew at 14.5% annualized, up from just 8.5% in the previous 12 months. Bank loans for purchasing securities are up a euphoric 50% year-overyear. The Fed is pumping up asset bubbles at a scary rate. That process is unsustainable. Something else is unsustainable: a negative savings rate. Although economists disagree on the wealth effect, the Fed clearly fears that the US will slide into a recession if a bear market spooks consumers into cutting back on consumption. The roaring bull market has reinforced the negative American attitude toward saving. For decades, the US has had the lowest savings rate in the industrial world. Because consumers have statistical proof that the stock market delivers 20%+ returns forever, they have responded by eliminating savings entirely: the personal savings rate has been negative for two months, something that no industrial country anywhere has achieved (if that

5.

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is the correct word). The entire consumer sector has apparently responded to the fashionability of new movies about insects to adopt the behavior of grasshoppers in the Aesop fable. The last time any major sector in the world became dependent on endless capital gains from stocks occurred in 1988-89 among the Japanese banks. The bloated banks real profitability had peaked, but they were still reporting huge earnings gains on their stock portfolios. The sequel to that collective folly was the reemergence of something that economists thought was dead: deflation.

The entire consumer sector has apparently responded to the fashionability of new movies about insects to adopt the behavior of grasshoppers in the Aesop fable.

Theres That Word Again

CRB Index since July 1997

Goldman Sachs Index since July 1997

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Crude Oil Futures since January 1997

Wheat Futures since January 1998

Lean Hogs Futures since July 1997

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It is time to challenge Sir John Templetons dictum. The five most dangerous words in investing are It is different this time. Consider: 1. Global money supplies are growing at their fastest rate in decades, yet The CRB Index is at a 21-year low and the Goldman Sachs Index is at a 25-year low, and Long Treasury bond yields are near an alltime low, and The US unemployment rate is near a 25-year low, and The NAPM Price Index is (according to Ed Yardeni) falling at the fastest rate in 50 years, and GDP Deflators have turned negative in several OECD countries.

It is time to challenge Sir John Templetons dictum.

2.

3. 4. 5.

6.

What do we think we know from decades of experience? 1. 2. A strong economy produces inflation pressures, and When those pressures become intolerable, the Fed raises rates, and The Fed lowers rates only when the economy is weakening and unemployment is a serious problem, and If the US and European economies are growing at satisfactory rates, commodity prices are at least firm, if not rising sharply.

3.

4.

What is different this time: the strength of global deflationary forces. They are overwhelming the cyclical inflationary pressures that should be ubiquitous at a time when unemployment exists primarily among NBA hotdog vendors and Republican political operatives.

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Not that inflation is extinct. Nosirree.

Not that inflation is extinct. Nosirree. For those many economists (such as Stephen Roach of Morgan Stanley) who have been awaiting inflations return for years, there is finally good news. Those two engines of inflationbig government and big tort law firmshave stepped in. Their settlement with the tobacco companies means a 35 cent increase in the cost of a pack of cigarettes, which will, like so many other government programs, redistribute wealth from the undeserving (smokers) to the deserving (lawyers and government) while giving a longed-for boost to the CPI. O frabjous day! Calloo! Callay! Other price boosts on cigarettes will be coming annually, which means tobacco will be making a positive contribution to the CPI for years. Deflation has been the principal theme in Basic Points for exactly 24 issues. (Our 1997 forecast, published in December 1996, was 1997: The Year of Living Deflatiously. This consistencyor fixationhas annoyed some readers. That we have stuck to it is not due to primal obstinacy but to our conviction that deflationary forces would pull overall CPI to lower levels than the consensus expected, which would mean bond yields would fall much below expectations. Initially, we assumed this would be good for stocks, but in recent months we fretted that US (and European) stocks might begin to emulate Japan. Since 1990, interest rates in Japan have fallen 93%, and stocks (at their low), were down 68%. US Stocks and bond yields fell together from mid-July to early October, which gave a distinctly Japanese flavor to Wall Street. Then stocks and bond yields rose together, maintaining this new, deflationary, correlation. Will it last?

Bubbles Past and Present

According to the Financial Times, US stocks are worth 53.2% of the value of all global stocks, up from 31% at the beginning of this decade. Japanese stocks are worth 10.4% of global equities, down from 41.5% in 1990. This is an unprecedented transformation of relative wealth.

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Of course, back then, Japanese stocks collectively were one of the twin bubbles that astonished the world, the other being Japanese real estate. Downtown Tokyos market value was greater than the combined value of all non-Japanese real estate in the world. Then the bubble burst. At its low valuation this year, commercial real estate in the Land of the Rising Sun was down 83% from its high. Basic Points has discussed the pricking of the Japanese bubble so often that the details of the story will not be repeated here. What is worth noting is that Pirandello-style role switch between top dog and loser. Nine years ago, the Japanese were Supermen and the US was entering terminal decline. Now the roles have reversed and so have stock valuations. I am told that if one deducts Microsoft, Cisco, Dell and Intel from Nasdaq, the multiple on the rest of the index is above 90. That puts this symbol of American success at the same multiple as the Nikkei in 1989,when it was a bubble waiting to be burst. As readers will recall, I believe that Japan and the US are reciprocals of each other. Japanese save, Americans spend. Japan has more than $1.5 trillion in external assets because of its endless Current Account surplus, and the US has net external liabilities of about $1.5 trillion from its endless Current Account deficit. 1987 was the last time those two stock markets made powerful bull moves together, and that flameout was a warning that the experiment must not be repeated. There isnt enough liquidity in the world to pump up those two mega-markets at once. The over-arching decision for all global fund managers is the Japan/US asset allocation. They move funds from one of those markets to the other, and that process ensures that available liquidity sustains at least one bull market. In 1990, Japan was the bubble that had begun to deflate, and the US was the hard-trying #2 stock market that was determined to catch up. Japanese excess liquidity was a big part of that American success story. The overt stage came in 1995 with the Reverse Plaza Agreement when Japan devalued the yen and single-handedly financed the US fiscal and

What is worth noting is that Pirandello-style role switch between top dog and loser.

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... the Giant Sucking Sound you have heard has been the US sucking in Japanese liquidity to pump up its bond and stock markets...

Current Account deficits. More recently, the Giant Sucking Sound you have heard has been the US sucking in Japanese liquidity to pump up its bond and stock markets at a time when US consumers are spending more than 100% of their after-tax incomes. This national splurge financed by foreign borrowing is a new form of Marshall Plan for Asia and the Third World managed by individual consumers, rather than through national or international agencies. The US consumer is the consumer of last resort. Those Asian and Latin American exporters struggling with brutal interest rates and sliding domestic economies rejoice in Americans willingness to consume beyond their incomes. That they can live beyond their apparent means is because they actually get richer even as they spend, because their stock portfolios keep appreciating. The New Paradigm: 1. Asia and Latin America are in serious trouble, and European economic growth is slowing. For all three regions, the key economic dynamic is exports to the US. Americans can afford to buy more and more of what Asia, Latin America and Europe produce because Americans no longer need to put aside money from their after-tax incomes with their stock portfolios appreciating rapidly and consistently.

2.

3.

Therefore, 4. If the US stock market enters a genuine bear phase, the whole world will slide into recession, which means that... All central bankers must continue to supply liquidity to the US to keep consumer spending up by keeping the stock market up. Whats good for Wall Street is good for Main Street and whats good for Main Street is good for THE WHOLE WORLD.

5.

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Except maybe Iraq and North Korea.

Enter Y2K
The only certain forecast for 1999 is that it will be followed by 2000. The only certainty about 2000 is that it will arrive amid massive uncertainty about the basic underpinnings of civilization as we known it. The only certainty about the preparations for computer functioning in 2000 is that they will cost more than $800 billion. Until witching hour on December 31st, no one will know for certain whether enough money was spent and whether enough of those funds were spent productively. The computer on which this is written has behaved with unusual unpredictability during the writing of this essay, involving many visits from Elaine Feldman, our wonderful computer support person. Elaine has been available because most of our other computers have been functioning normally. Whilst I do not suggest any mystical connection between the theme of this publication and the breakdowns in the computer, it is, perhaps, a useful reminder that at yearend 1999 it will matter very much to us all that all the computers on which we rely, directly and indirectly, work at the same time. Amid all the hype and debate about Y2K, one fact is clear: whether all the computers work or not at midnight for this millennium, consumers everywhere are going to be hearing a lot about the potential disasters if some key computers fail. Without making a prediction about the actual impact of Y2K, let me just assert that the buildup to the millennium is going to put great strains on many consumers confidence. Apart from the likely beneficent impact on sales of canned food, wine, guns, and Bibles, the main effect will probably be widespread uncertainty or fear.

Apart from the likely beneficent impact on sales of canned food, wine, guns, and Bibles, the main effect will probably be widespread uncertainty or fear.

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...Americans will be forced to increase their savings and that would be bad news for Wal-Mart.

Now, American consumers are impervious to such consumption deterrents as negative savings and negative price increases. Perhaps they will remain in this splendidly optimistic mode right to the Millennium, continuing to tap on foreign savers to finance their cheerful lifestyle. That implies that the stock market doesnt decline, because if it does, Americans will be forced to increase their savings and that would be bad news for Wal-Mart. And, as we observed, for THE WHOLE WORLD. What about consumers in less insouciant lands? Will Eurolands consumers cut back their already modest spending if they worry that Y2K will arrive amid disaster?

Fragility
Never has the valuation in the US stock market been so dependent on continuation of the robust US economy. Even above-trend growth of 3.8% in the Third Quarter wasnt enough to prevent corporate earnings from declining. It doesnt bear thinking what would happen to earnings if real growth were near-zero. Never has the US economy been so dependent on the US stock market. Some part of consumer spending comes from realized capital gains. Far more of it comes from consumers willingness to spend up to and beyond their incomes because their wealth is growing so fast in the stock market. Never has the valuation in European stock markets been so dependent on continuation of the robust US economy. Such strength as Germany displays ( the economy that accounts for 33% of Euroland GDP) is in exports, as capital spending and business confidence slide amid growing evidence that the new government is the most dangerously ideologized administration to take power on the Continent since World War II. The markets gains are coming from rising multiples on flat or falling earnings and infinite multiple increases on nonexistent earnings.

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Since it is absolutely crucial that the stock market keep climbing, humanitys greatest benefactors are those few brave, bold thinkers who conceive new reasons to buy stocks. The finest such burst of creativity in recent weeks came from a prominent Wall Street strategist. He pointed out that if you eliminate from the S&Ps down earnings the results from the Financials, the Oils, and General Motors, earnings were actually up 9.5%, so the market is actually inexpensive. The justification for dropping 26% of the market cap of the S&P is that those earnings hits were one-time events, although not technically non-recurring. What makes this such a breathtaking breakthrough is that he has extended the Great Discovery of the 1990s into new territory. During this bull market, the most important new idea was that All Losses are Non-Recurring and All Profits are Recurring. Because of this insight, companies have been able to grow their reported earnings while admitting to what would otherwise be Zantac-inducing losses by closing plants and firing workers. Now, we can apply this principle to any reported losses so we never have to face bad news and the market can go up forever. According to this revisionist view, the Financials earnings hits came, like Boeings, from totally unforeseeable problems in Asia and Russia. Who would have believed that an Asian collapse would lead to a commodity collapse that would lead to a Russian collapse? The Oils were hit by that totally unforeseeable oil price slump that will never happen again. And General Motors earnings were hit by a strike, which of course could never happen again because General Motors and the UAW are more in love than Prince Charles and Camilla. Meanwhile, all the wonderful things that happened to the economy and the market are mere foretastes of the joys to come. It is reassuring to know that we can count on Wall Street for that kind of thinking when we need it most.

... because General Motors and the UAW are more in love than Prince Charles and Camilla.

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In the real jury to whom Clintons lawyers are appealing,How now, down Dow? is a potent argument for acquittal.

The Clinton Correlation

The linkage between the Presidents approval rating and the stock market meant that Basic Points devoted two issues in 1998 to discussing Clintons prospects with reference to the theatrical form of tragedy. Mr. Clinton, we noted, has a unique relationship with Americans hearts. He encapsulates their essential optimism, his color-blindness speaks to their deepest aspirations of goodness about race, and his roguishness is captivating, particularly when compared to Republican fuddy-duddies like Bob Dole or the more strident spokesmen of the Christian Right. He has understood all along that the displacement of defined benefit pension plans by 401(k) programs meant that the majority of voters now cares deeply about the stock market. The Dowand particularly the Nasdaqused to be abstract concepts identified with rich Republicans in the minds of most Democratic supporters and many Independents. No more. As the Bible expresses it, Where thy treasure is, there shall thy heart be also. CNN now carries the Dow in a box in the lower right of the screen, a recognition of the correlated loyalties of viewers of the impeachment hearings. In the real jury to whom Clintons lawyers are appealing, How now, down Dow? is a potent argument for acquittal. At times, his lawyers are almost frank about the logic of dropping the proceedings so that no financially painful consequences will occur. The Clintonistas are steeped in the lore of Watergate. Hillary, who has been the Presidents most formidable ally, was a junior counsel in the Nixon impeachment proceedings. She is doubtless well aware of an eerie political coincidence. In the 1972 Presidential election, held after the Watergate breakin, but before the revelations about the White House plumbers, Richard Nixon, perhaps the least personally appealing President to occupy the White House in this century, demolished the Democrats. He won 60.69% of the

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popular vote (against a pitiful 37.53% for George McGovern) and took 520 electoral votes to McGoverns 17. As the Washington Post hammered away on the Watergate story, Nixons approval rating remained overwhelmingly high. Then came the Arab oil boycott, the lineups at the gas pumps, 14.7% inflation, and the worst bear market since 1929. Nixons approval rating sank along with the Dow, and the committees persistence finally led to the smoking gun of the tape. Nixon resigned to avoid impeachment. In comparison, Mr. Clintons landslide re-election win was rather modest. He got just 49.7% of the popular vote, compared to 40.7% for the dull Dole, and 379 electoral votes to Doles 159. Even this performance was heavily due, according to Dick Morris, to the Democrats brilliant and massive abuse of campaign funds which were supposedly restricted to soft uses. Mr. Morris, co-author of this strategy, bragged that Dole was dead before he got the nomination because of TV attack ads on medicare, education, and social security. The Federal Election Commission has confirmed that the Democrats did violate the laws, but Janet Reno, the most loyal Attorney-General since John Mitchell, has given the White House yet another pass. (The FEC said the Republicans also broke the laws, but their defense is that they only woke up to what Clinton was doing late in the campaign, and acted in retaliation. In sports, the player who slugs back when hit is also penalized for fighting. In politics, two wrongs dont make a right to prosecute either offender, it appears.) Basic Points argued that Mr. Clinton would probably be forced to resign, not because of Monica, but because Monica-related mendacity would be seen as part of an overall pattern of lying and stonewalling. Most important, I suggested, would be revelations of the export of sensitive missile technology to the Chinese after receipt of illegal campaign contributions from that government. That the Chinese were given sensitive missile technology against the express wishes of the Defense Department and national security advisors has long been established. That they got it because Mr. Clinton took away the approval process on such technology from Defense and national security agencies

In politics, two wrongs dont make a right to prosecute either offender, it appears.

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Perjury and obstruction of justice could be impeachable offenses if the Dow were at 6,000 and the economy were in recession, but not when everything is going so swimmingly.

and gave it to the deeply politicized Commerce Department has also been established. That Johnny Huang and Charlie Trie channeled illegal funds from the Riadys and other Chinese organizations to the Democratic National Committee is also established. Of the many witnesses Congress has sought in its investigation of this rapidly-developing scandal, few have been available for testimony. Some have skipped to China. Others have taken the Fifth Amendment. Others, such as former Commerce Secretary Ron Brown, are dead. It is part of Clintons amazing luck that in all his scandals, key witnesses die, disappear, or, like Web Hubbell, stay silent after receiving hundreds of thousands of dollars for undisclosed services. One of the less-remarked aspects of Monicas conversations with Linda Tripp was her warning to Ms. Tripp that testifying against the President could be dangerous to her health. What should be obvious to even the most embittered Republicans is that Americans will not back impeachment of Mr. Clinton as long as the stock market and the economy remain strong, no matter what he has done. Perjury and obstruction of justice could be impeachable offenses if the Dow were at 6,000 and the economy were in recession, but not when everything is going so swimmingly. As Alan Greenspan noted in July, the American economy is in the best shape he has seen in a lifetime of watching economic indicators. He was readying the markets for a boost in the Fed Funds rate. Mr. Greenspans earlier optimistic assessment is still shared by most Americans, although we must assume Mr. Greenspan has changed his mind. Whats clear is that his drastic policy change turned a roaring bear market into a roaring bull market in time for the election. That election seems to have ended chances of impeaching the President, even if the House, on party lines, votes for articles to send to the Senate. Maybe the final word on this melancholy story came last week in a report on a scientific breakthrough. Two scientists announced the first decoding of the genome of an animal, a microscopic worm. Another expert summed up the

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significance of this discovery: In the last ten years we have come to realize humans are more like worms than we ever imagined, said Dr. Bruce Alberts of the National Academy of Sciences.

Looking Backward and Forward

The biggest forecasting error I made in 1998 was assuming that the Asian Plague and global deflation would lead to lower stock prices. What really happened was that lower bond yields ignited Nifty 25 stock prices, and lower gasoline and natural gas prices fueled consumer confidence and consumer spending. As has been noted many times before, a plunge in oil prices acts like a tax cut in the industrial world. Economic growth in the US and Europe was stronger than I expected because the good effects of deflation on prices of foods and fuels more than offset the financial uncertainties created by turmoil in Asia, Russia, and Latin America. I completely failed to predict the boom in technology and Internet stocks. These companies benefited from falling interest rates and rising consumer optimism. They were virtually unaffected by the Russian crisis and only modestly hurt by turmoil in Latin America. The Internet functions mostly in English. Looking forward: 1. I feel confident that technology and Internet stocks will continue to lead the market, but assume they will lead it down. This most speculative of all stock markets cannot forever rely on a consumer economy in which consumers spend more than 100% of their after-tax incomes, relying on continuation of outsized capital gains. The dollar will continue its slide against the yen and the Eurocurrencies, which will encourage foreign investors to cash Wall Street profits and move their funds abroad.

In the last ten years we have come to realize humans are more like worms than we ever imagined...

2.

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Another global financial crisis looks probable, despite all the easing by all those central bankers.

Europeans were important in driving the mega-cap stocks to the stratosphere. When the Europeans depart, those stocks will suffer from anoxia. 3. The commodity bear market will not reverse in coming months, but will not continue to fall so rapidly. Nevertheless, the US and European economies look very vulnerable, so the bottoming-out in Asia will not mean a new commodity boom in 1999. 4. Another global financial crisis looks probable, despite all the easing by all those central bankers. Liquidity certainly helps to prevent disaster, but lower interest rates in the G-7 dont make commodity-producing nations good credit risks. Commodity prices have fallen much harder than interest rates, so investors are probably too sanguine that the Fed can continue its omnipotence. When you are the central banker of the country with the biggest external debt, the lowest domestic savings rate, and the most speculative global stock market, your options are limited.

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Investment Conclusions
1. Investors should remain heavily overweighted in bonds and should maintain long duration within those portfolios. There are two obvious risks in long bonds excessive money supply growth and a weakening dollar. However, the rewards from deflation continue to outweigh those risks. Gold continues to shine by being dull. Gold bullions volatility has been at the barely perceptible level during some of the most tumultuous markets in history. Quality gold mining shares remain the best haven for resource stock investors. The next time the attackers ride over the hills, our hero Alan and his trusty men will have a depleted supply of bullets. If you cant stand violence, you should seek other havens than big-cap stocks. The renewed underperformance of US Financial stocks and the widening of the TED Spread suggest that the next skirmish will come sooner, rather than later. If you are planning on leaving for vacation for the holiday season, you may wish to leave some stops. The combination of converting for both the Euro and Y2K means that European computer systems will be more stressed than North American. Y2K will be the most-awaited event of our time. Hope for a nonevent, but dont bet heavily on it. The hype could be a severe blow to consumer confidence during a year when that seemingly unassailable optimism will have plenty else to chew on. Cyclical stocks should continue to underperform. As interest rates fall, dividends suddenly become meaningful. During this long bull market, dividends have slid into obscurity. Reliable dividends could be the most beautiful feature of equity portfolios if the global situation continues to deteriorate and US consumers are forced to retrench.

If you cant stand violence, you should seek other havens than big-cap stocks

2.

3.

4.

5.

6.

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1999 should be the first year in this decade that Japan outperforms Wall Street.

7.

Japanese stocks are joining other Asian markets in establishing a convincing bottoming pattern. 1999 should be the first year in this decade that Japan outperforms Wall Street.

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Basic Points is a publication prepared by Donald Coxe of Harris Investment Management, Inc. (HIM) for the exclusive use of clients of Nesbitt Burns, Nesbitt Burns Securities Inc., HIM, Harris Trust & Savings Bank, Jones Heward Investment Management Inc. and Jones Heward Investment Counsel Inc. (collectively referred to as the Global Asset Managers). All rights reserved. The opinions, estimates and projections contained herein are those of HIM as of the date hereof and are subject to change without notice. HIM makes every effort to ensure that the contents herein have been complied or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, HIM makes no representation or warranty, express or implied, in respect hereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use or reliance on this report or its contents. Information may be available to the Global Asset Managers which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global Asset Managers and their affiliates and respective officers, directors or employees may from time to time acquire, hold or see securities mentioned herein as principal or agent. Any of the Global Asset Managers may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is a direct or indirect subsidiary of Bank of Montreal. To US Residents: Nesbitt Burns Securities Inc., HIM and Harris Trust & Savings Bank accept responsibility for the contents herein, subject to the terms as set out above. Any US person wishing to effect transactions in any security discussed herein should do so through Nesbitt Burns Securities Inc..