[continued from pt. 1]
P&I: Peter, your thoughts on large-cap growth vs. small-cap growth vs. large-cap value vs. small-cap value?
MR. ANDERSON: I don't think there are any gross differentials in valuation between those categories. I think the action in the market is reasonably well balanced at this point. I think in general it's modestly overvalued, but the balances between sectors are actually pretty good. Having said that, I think there is a little more overvaluation in large-cap growth land, particularly in the consumer growth area: Coke, some of the drug stocks and others.
In the large-cap area, the cheapest single sector of the market, in my opinion, is technology. It's cheap for a reason: the high level of earnings volatility. But, nevertheless, I think there is real opportunity. But you are going to have to go stock by stock by stock by stock. In large-cap land, I would be focusing on technology and I would be focusing also on the financials, in part because of the ongoing consolidation in the industry. I do not see that changing. Although our interest rate scenario with rising interest rates early in the year is a little bit unnerving and could result in some kind of a correction, for the year as a whole I think financials will be fine. I do think small-cap growth is modestly, very modestly, undervalued relative to the general market. I think there are a lot of opportunities in that area.
Again, I would take a look at technology in the small-cap area for the same reason. I think it's distinctly undervalued, but very tricky and it really is a stock by stock by stock approach that you have to take.
MR. WEISS: It seems to me as we move through the year, we have some earnings concerns cropping up for '99. It's going to be tough, relatively tougher for the value side of the equation to work real well. Value tends to work well when you have confidence about earnings. I agree with Pete that the overall range of valuation is not as wide from one sector to the other as it has been historically. I think the growth side of the equation will do a little bit better because of the earnings concerns, but the individual company had better deliver the goods. There's going to be a focus on high probability earnings.
MR. ANDERSON: More than in the past, I think this is going to be a market of stocks rather than just a stock market. Particularly that's going to be the case if you have rates of return of zero to plus 10%. We are at zero and a number of the other guys around the table are, let's say, plus 10; Alan is even better than that. We all look for rates of return substantially lower than this year's. That implies to me you are really going to have to focus on stock selection; the market is not going to carry you in a major way.
P&I: Alan, where in these four universes would you look for your stock selection? Large cap vs. small cap, growth vs. value.
MR. BOND: I have to look at what has happened this year. A lot of the opportunities have been in the midcap category. When I look at valuation, I think midcap stocks are still very much undervalued. We manage midcap and large cap, and it's been a constant issue of our midcap stocks outgrowing their midcap status and then graduating into the large-cap universe. I see that continuing. In fact, you have got the smaller companies that have grown and become midcap names and then they have grown right into large-cap companies.
In terms of value stocks, because of the merger and acquisition wave, I would have to say there is still attractive value out there. I don't know if I share Pete's feeling about technology in the sense that I can't say with conviction that you are going to be compensated for the risk you expose yourself to when you buy a tech stock in the current investment environment. You can by a tech stock that has a beta of 1.7. You can buy a bank that's going to be fairly steady and consistent, or has been, and get the same kind of appreciation.
MR. WEISS: If I might respond to Alan in one sense, on the technology thing. I think there is an interesting positive trade in January in technology. I don't know about the rest of you. I am looking at a number of technology names -- Teradyne, KLA -- these are great companies down 40%, 45%. I have a new clock that starts 1/1/98. I think there is going to be a brief pop in those names and then we will have to see whether it is sustained. I think there's a lot of capital that's going to flow in after the first of the year. Some of these great companies have been really tagged here.
MR. KIM: My conviction level is less strong between growth and value, but for '98 I think there is clear evidence that small caps will outperform large caps. First of all, on a valuation basis going into the new year, small caps are less overvalued. In fact, using five-year historical analysis, I calculate a fair valuation for much of the Russell 2,000 stocks.
Then you have to consider the effect of a stronger dollar on the multinationals, which obviously will have a negative impact on large-cap stocks in favor of small-cap stocks. The inherent earnings growth rate of small caps is much stronger than for large caps. Then some of the takeover phenomenon obviously would fall into the category of benefiting small-cap stocks. So our biggest view within the general equity sector is that the run on large-cap stocks outperforming small-cap stocks of 31/2 years will end in '98.
P&I: Comment on U.S. equity returns vs. international markets returns. Which of the foreign markets do you expect to perform best and why? Which ones will likely outperform the U.S.?
MR. KIM: If I look at the top 15 to 20 of the major financial markets with adequate liquidity and investibility, I think actually the U.S. markets will fall in the top quarter on a risk-return performance basis.
I think the outperforming financial markets next year will be in Europe, and primarily in continental Europe; those economies that are anticipating and preparing for European monetary union. You are going to see lower interest rates, a great deal of corporate restructuring, and a much more cheerful or friendly attitude again going into EMU of 1999.
I don't think Latin America is going to fare very well. Mexico might be the lone exception there; Brazil is going to have a difficult time working through its fiscal austerity program. Asia I would just write off altogether for 1998. Japan is intriguing but I think it's still too early.
MR. BERGSTROM: We are seeing some of the best opportunities in certain selected emerging markets plus, broadly speaking, in some of the smaller capitalization sectors, both in Europe and in Japan these days.
Let me talk a little bit about the small-cap sector and the developed markets first. One of the things that hasn't gotten a huge amount of press coverage in the U.S. is that while Japan has had basically an eight-year bear market, during this period the smaller cap names have underperformed the broad-based large-cap industries by truly dramatic amounts. By "truly dramatic" I mean year-to-date the bottom decile in Japan roughly has underperformed the large-cap index like the Morgan Stanley Japan index on the order of 2,500 basis points. Generally, they underperformed for most of the '90s. All of a sudden this is a sector where there are lots of companies selling for way less than book value. A lot of them selling for a lot less than the value of the net cash on the balance sheet. Some of them even are going to have better earnings next year. There are some opportunities there, if you are willing to take the long-term view.
Also, if you know what you are doing in Europe, there are some very inexpensive smaller medium-cap companies around; maybe not quite as dramatically as you see in Japan right now.
As we judge it, they are starting to get some pretty good opportunities in a number of the Asian markets. You don't have to rush out and buy them this week; probably not even necessarily the next three or four or five months. But you have a lot of markets that once sold for 25, 30, 35, even 40 times trailing earnings that you can now buy in single-digit p/e levels. Everybody in the world who hasn't been sleeping knows that the earnings in many of these places pretty much will disappear next year but if you can afford to take a two-, three-, four-, five-year view, we think that over the next six months there will be some excellent opportunities to buy a number of Asian markets.
Thailand, if the politics sorts out, probably would be one of the ones to look at relatively early because, after all, that's where the whole Asian disease started and they have been well into a recession before a lot of other economies.
Going beyond Thailand, I don't think there is any great rush necessarily in Indonesia or Malaysia, but I think eventually there will be some good opportunities there. Also, plenty of emerging markets don't look very attractive as we judge these things. Taiwan would be on that list, for example. Depending on how far afield you want to go, we don't much like Zimbabwe these days. The politics seems to be going in the wrong populist way again.
MR. ANDERSON: First, whatever I say does not represent the views of our international asset managers, because their position almost diametrically is in a different direction from mine. They are the experts, so we will go with them. But this is what I would do:
Number one, I am intrigued with Japan. I think you may need to have some patience with Japan, but I would definitely be a buyer. I was at a conference in the Bahamas put on by Morgan Stanley about three or four weeks ago. I was struck by the overwhelmingly negative views on Japan. The big weightings were 1% and 2% in the world's second largest equity market, and a bunch of folks there were proudly announcing how they were short the market. When folks are all on one side of the boat, as they were at the same conference in 1990 regarding the banks, when they have all acted out their angst, you are set up for some kind of a move in a market, and I think we are set up for a move in Japan.
In the rest of Asia I am a little uncertain, but suspect that at some point in the year we are going to have massive rallies in these markets.
Clearly we have a couple more shoes to fall here. Interest rates almost across Asia, with the exception of Japan, will have to remain relatively high in order to protect the currencies.
Number two, these countries are going into recession. I think that's inevitable. That implies we will see severe earnings disappointments in these countries and the financial structures in these countries will be under great strain throughout much of the year. But having said that, the currencies already have collapsed, the markets already have collapsed, and there is an awful lot of bad news priced into them. At some point in '98 I think we will have a significant move in these markets.
On the other hand, Europe is in the same boat, as far as I am concerned, as the United States when you define the markets in their local currency terms and not in dollars. When you define them in dollars, it hides what actually is going on in the local markets. These markets have had huge moves and they are no cheaper in some cases than our U.S. market, and in a few cases not as cheap. So I do not find Europe to be a particularly compelling value, although I would agree with the comments that have been made that the economies of some of these countries are in pretty decent shape.
As for Latin America, I am simply uncertain. I think again Latin America will be not a continent but rather a set of markets in which you will have to make judgments on each individual market. I agree with the thought that Mexico at this point might be a very attractive place to be. Brazil, on the other hand, might not be. You have to really take it case by case by case by case.
But I am really intrigued by Japan and to a lesser extent I am interested in the rest of Asia.
MR. KIM: Let me make a comment about Peter's bullish case on Japan here. Peter is absolutely right; it's due for a turnaround. But when you consider 40% of Japan's exports are to the Asian economies, then it is baked in the cake that they are going to experience a severe recession. I'm just not sure if '98 is going to be the turnaround year, but at some point it's going to turn around. I would just wait a year or two.
MR. ANDERSON: I couldn't agree with you more that the economic fundamentals do not support my case, no matter how I try to look at them. It's more an instinct about the market, because the economic fundamentals do not support a bullish case.
MR. BERGSTROM: On the other hand, just about anybody in the world of finance knows all these negatives that we just talked about. I think it's probably pretty well priced in a lot of sectors of the Japanese market. I would just add a little addendum to some of your comments, Peter.
I think in Japan it is important again what sectors you focus on, in the sense that at one extreme I suspect there are a number of Japanese financial institutions that, rather than having a rally if the overall market rallies in the next 18 months, could very well go out of business. We have seen plenty of it already.
There could be more, as much as we saw in the U.S. in the early '90s: A pretty good rally in the overall market, but a few companies headed south. I think stock activity in Japan will be important.
Certainly, again, if you can take the two-, three-, four-year view, there do seem to be some real interesting in values.
P&I: Jim, your thoughts on the non-U.S. markets vs. the U.S.?
MR. WEISS: It seems to me when we look at the U.S. dollar returns that we are going to get in 1998, a year from now, I think the U.S. probably is going to fit in about the middle of the pack. I think there is a good chance we are going to see maybe a half-dozen pretty good snap-back rallies.
You had a real knee-jerk reaction here where you had the unfolding currency problems in Asia and all these markets in Asia were trashed and we moved on to Latin America in a wink. We went after a number of economies in Latin America and I don't think they are all equally in bad shape. I think in a couple of Asian countries, and in Latin America in particular, you will see some 20% moves over the course of 12 months. That will surprise people.
Then take a very credible 8% or 9% total return in the United States and force it into the middle of the pack.
In terms of good ideas, good places to be, I would look at the fringe countries in Europe.
MR. BOND: I just can't see advocating investing in the Asian countries at least for the next year and a half. I just think the shoes haven't finished falling. I think there will be further bankruptcy announcements out of Japan. If you look at it in an absolute sense, yes, it's cheap. Could it get cheaper? Maybe so. Is there another 10% downside?
I would agree Europe does seem to offer some opportunity. And I am slightly encouraged by developments in Mexico. I would be very concerned about Brazil, even as it affects the U.S. banks. We had one major money center bank announce they had some bad trades with Brazilian debt. I think we are in the midst of this story unfolding, and the volatility in the world's financial markets causes me great concern, which is why from a domestic standpoint I think the U.S. will probably lead the way.
P&I: Nobody has talked really about Eastern European markets. Are there any markets there that look attractive?
MR. WEISS: With respect to Russia, statistical returns have been terrific. But try to book those profits and see what your return is after the transaction.
P&I: Somebody mentioned Taiwan as their least favorite market. What other least favorite markets are around the table?
MR. KIM: I dislike Malaysia and Indonesia. They have got structural problems there: corrupt government, massive overspending and virtually no regard for cost of capital. Again, the capacity is just way beyond the demand for many of the industries and products that they support. There is a lot of political cronyism and there is an attitude that they do not need to go through the prudent austerity programs to get back on the world economic track. It's going to take many years -- painful years -- for them to work through some of the ills they have created over the past half decade.
MR. BERGSTROM: I would have a few add-on comments in terms of some of these Asian economies. You look at a market like Thailand. Do we know there are plenty problems in their economy? Absolutely. Has the stock market taken notice? Well, it's down close to 90% in U.S. dollars. I think it's taken some notice. The real judgment call going forward is -- since everybody pretty much knows the medicine that's required to get the economy restructured and growing again -- is there going to be the political will to take the difficult decisions the IMF is telling them it ought to take and everybody who is knowledgeable knows ought to be done?
P&I: Peter, your least favorite?
MR. ANDERSON: Again, the views I express are my own views and are not necessarily of my investment staff overseas.
I just wonder about India. You have huge turmoil in the country now. The government has collapsed. It's likely to be replaced by another government. Plans for privatization, deregulation appear to be perhaps delayed or in abeyance, and the Indian government is notoriously corrupt and rotten; rotten to the core. To me that spells some kind of trouble. And it hasn't been as fully played out in India as it has been played out in some of the Asian countries where the financial markets almost fully reflect the disaster case.
MR. WEISS: I tag on to Pete's comment. In all the discussions about the Far East, there seems to be an exemption for China and India. You have really two issues there: Will there be more problems than we are acknowledging? And, the market hasn't accounted for it, so you have risk of it being disappointing.
But I guess I'll join my colleagues around the table and pick on Malaysia. It's easy to pick on. If you want to have a negative view, one of the key issues all around the world is: Do you have the political will to step up and admit the problem, measure the problem and take the medicine? You have to have serious questions about several governments in Asia in terms of whether that will exists.
I think Brazil is kind of interesting. I'm not sure I'd bet the ranch on Brazil at this point, but they have an interesting role model in Argentina. They watched Argentina two years ago do a pretty effective job of dealing with the crisis and coming out the other end in good shape. They are bright people. So we may actually get a positive surprise out of Brazil in that they deal in a forthright manner and suffer less damage when the game is over than we all kind of wonder or worry about today.
P&I: Alan, any other thoughts?
MR. BOND: I was glad that Jim mentioned China; that would probably be the economy or market I was thinking of. I look at some of the larger economies out of Asia and I think about what led to this problem, what was the reason this happened. I think about the excessive investments that were made in the country and now there is too much capacity. Will they do something about it?
P&I: We have all touched briefly on the outlook for long-term Treasuries. What about corporates? Is the spread going to change enough to make them more attractive?
MR. ANDERSON: I think the economy is going to slow in the second half of '98 and that slowdown will continue into 1999. It only makes sense to me that the spreads have to widen out. Certainly they need to widen out in the junk area. Until the recent currency turmoil, spreads were historically at narrow levels. So I think spreads in general in the corporate area have to widen, but particularly in the junk arena, I think they will widen over the next 18 months.
MR. BOND: I would agree with the comment. Right now looking at the way spreads are it doesn't make sense to go out more than 10 years. Obviously if we get a slightly more varied yield curve and the economy starts to slow down toward the second half of '98, we might see some spreads start to widen a little bit.
MR. KIM: I take the opposing view. Absent a recession, which I don't think has been predicted here to '98, and I don't believe we are going to enter into a recession period in '99 either, and with default levels for corporate bonds, both high-grade and below-investment-grade really at their historic lows, I don't see why spreads shouldn't narrow here.
A slowdown in the general economic environment has to be coupled with higher default rates. I think corporate America's balance sheet is just far too strong; very strong cash positions, not very leveraged; and I think they have been quite prudent here over the years in their debt management. So I am relatively sanguine on spreads, both high grade and high yield.
MR. ANDERSON: Although I believe the spreads will widen out fairly steadily, there is another factor which I think actually supports John's case. An awful lot of people are desperate for yield right now. That's true in the insurance area and I think it's true in many cases in the retail investment area, but definitely in the insurance area. When you are desperate for yield, where do you go? You go to corporates, but what you really do to the extent you can is to go into junk or go into the very weak end of investment-grade corporates.
P&I: Which brings us to the question of other asset classes. Are there other asset classes that might be attractive to U.S. institutional investors in the next year or so?
MR. ANDERSON: Hedge funds in the United States and around the globe have been growing at a pretty rapid clip. I think in the environment I see out there, they are really going to come into their heyday.
While I see a zero rate of return, I see substantial volatility. In that kind of environment if -- and it's a huge if -- you have the ability to capitalize on that volatility, both long and short, you have an ideal view. I think it ought to be a very attractive environment over the next 12 to 15 to 18 months for hedge fund operators.
MR. WEISS: We are in the process of launching an energy-based hedge fund; out making calls right now. I ran into one of our senior marketing people and she thinks we are going to raise half of our capacity in that fund by the end of January.
MR. KIM: This sector is less relevant for institutional investors, but I think the very smallest of the small caps, the micro-cap sector defined with the market cap of $300 million or less, is very attractive. They will be almost entirely immune from the problems overseas. They are, in many cases, the fastest growing sectors and those also are the stocks or sectors where, if you pick the right stocks, you can just have a wonderful year.
MR. ANDERSON: Going to real estate for a moment. We are seeing a tremendous demand for commercial real estate of all kinds. People are just stumbling all over themselves to buy properties. We all know how this thing goes. When you get a real head of steam behind it, it goes to an excess. I would not say we are at the point of excess yet, but you can smell it coming and I think we are going to see a boom -- we are already seeing a boom -- in the commercial real estate market.
That boom will continue for a period of time and then we will, as we always do, take it over the top. But I would suspect that over the top is two, three, four years out.
P&I: What insights can we draw from the volatility we have had since October? What lessons have we learned or should we learn?
MR. BERGSTROM: One thing you can say about volatility, it's a pretty reasonable bet there is going to be a reversion to the mean. In early '96 I felt comfortable saying, "I think the markets are going to get somewhat more volatile." Now I am fairly comfortable saying, "We had a pretty good dose of volatility lately and the odds are we are probably headed back down here over the next six months or year or so."
But absent one or more unpleasant big surprises, I would look for volatility to probably moderate from the levels we have seen in the last couple of months in the U.S. equity market.
MR. WEISS: I disagree a little with Gary. If you look at recent studies and look at the volatility level for 1997, it looks very similar to the level of volatility we had for 1985 to 1991.
I think, number one, the reason this volatility is so striking is we got lulled into a sense that the aberration of the last two or three years was in fact the norm. It wasn't. Number two, the level of volatility we are at now is not particularly high on a historic basis and we have seen periods where this volatility has gone on for two, three, four years. I think it will revert to the mean, but I think the next six months is a little quick to have that reversion occur.
P&I: Alan, what do you think?
MR. BOND: In terms of what we learned from October, we learned a lot, I think.
The globalization of the financial markets is ever more relevant, but the linkage of those markets to one another is even more serious and significant than ever.
Now we have to step in and bail out some of the other economies. Let's just hope that we don't overinvest and overindulge in our own economy so that three to five years from now the U.S. economy is in severe recession and interest rates have skyrocketed. Because then we will be thinking back, "Why didn't we learn from what we witnessed?"
MR. KIM: I agree. In the past when the U.S. sneezed, other economies got a cold. I think if any meaningful economic entity sneezes going forward, there is a higher likelihood the U.S. economy will catch a cold. We are truly a global integrated marketplace.
MR. ANDERSON: It's a tiny little taste of what is going to come. Eventually, we are going to run into an economic phenomenon stemming from overheating and higher interest rates; or it may be something abroad.
And I think the volatility will prove to be simply unbelievable, driven by derivatives, driven by the fact the market has been completely institutionalized, driven by the fact that what is left of the direct retail investment community is now "sophisticated" and driven by foreign investors who are nothing more than herd animals.
All of that spells to me volatility, and when the market actually does turn down -- and I don't mean this little bitty 500-point decline -- it will do so with a vengeance.