1999 basic points

8/4/2019 1999 Basic Points

1/29

1999: Double Bubble

December 14, 1998

PointsBasic


2/29

Recommended Asset Allocations

American Portfolios

U.S Pension Fund

Allocations Change

Domestic Equities 26 unch

Foreign Equities 7 unch

Domestic Bonds 64 unch

Foreign and Foreign-Pay-Bonds 3 unch

Cash 0 unch

Bond Durations

Years Change

Global 4.25 unch

U.S. 6.25 unch

Canada 5.0 unch

Unless otherwise stated, charts are courtesy of Bloomberg.


3/29

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 mentalincompetence is trying the same experiment over and over, each time expecting a differentresult.)

Last years Basic Points predicted that deflation would be the underlying trend in globalcapital markets. PPI would routinely be in negative territory, ultimately driving the GDPDeflator in much of the industrialized world into negative numbers. Bonds wouldoutperform 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 UScorporate profitability was seriously endangered. In the summer, its corrosive effects onthe financial system triggered a full-blown crisis. That roused the Fed and other centralbankers 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 ourforecast. 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. Stocksmodestly 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 longestdeflationary bear market in history. Pumped up by a seemingly frantic Fed, US stocks arein a double bubble formation: inflated multiples of inflated earnings forecasts.

Deflation will continue to be the big story in 1999, despite rapid money supply growththat has monetarists predicting inflations return. It will be a vintage year for whines, ascompanies report recurring non-recurring losses blamed (like Boeing) on the surprise thatAsia 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 Husseinwillcontinue to flummox their foes for a while, but 1999 could be the year that at least oneof them gets his comeuppance. Asian stocks, led by Japan, will outperform US andEuropean stocks.

We wish clients a Happy Hanukkah, a Merry Christmas, and a relatively uneventful NewYear.


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S&P Index since January 1, 1998

30-Year Treasury Yields since January 1, 1998


5/29

page 1

It has been the best of all possible worlds. Money supply is upbig. Bonds are up big. Big-cap stocks are up even bigger. Realestate prices are up. The economy is up. Democrats are up.

Whats down? Republicans, corporate profits and

commodities. Republicans learned that the voters are willingto let Bill Clinton take credit for everything except what heactually did. Commodities have been sliding for years andcorporate profits have been sliding for months, and investorshave learned to regard them as mere distractions from theserious business of having fun in the Clinton bull market.

Come back with me to that long-ago time, (now nearly lost inthe mists of history) of October 1st 1998, when the BestMinds (including Bill Clinton, Robert Rubin, MichelCamdessus, and George Soros) were warning that the worldfaced its worst economic and financial crisis in fifty years.Global stock markets were trembling. There was widespreadtalk of recession, even of Global Depression. Major financialinstitutions shares were being savaged.

Basic Points

Donald G.M. Coxe (312) 461-5365/(416) 359-7019Chairman and Chief Strategist,

Harris Investment Management Inc.

Chairman, Jones Heward Investments

e-mail: [email protected]

Anne Stephaniuk, Publishing (416) 359-5083

e-mail: [email protected]

1999: Double Bubble


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

But then, something wonderful happened. The crisisdisappeared 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 bankersflooded the financial system with money. There had alreadybeen great liquidity sloshing around financial markets, butwidespread abuse had wasted much of it, constricting its flowinto some very important and suddenly very parched areas.Like a January rainstorm in Arizona that produces floods inthe gullies, the joint action of the monetary gods was sudden

page 2

But then,

something

wonderful

happened.

The crisis

disappearedwith magical

speed. It was all

a bad dream.


7/29

page 3

and impressive, producing an explosion of efflorescence in itswake.

US Money of Zero Maturity, Year/Year % change

since January 1, 1998

Chart courtesy of Nesbitt Burns Economics

The markets turnaround and rally confirmed what manyretail investors have felt all along: this bull market is driven not

only by strong fundamentals (such as Q3 GDP growth of3.8%), but by a supernatural force. Just when the Dow and theS&P were down 19.9% and threatening to break 20%, (whichwould, under the Accepted Rules, have confirmed a bearmarket), they turned and roared back, evenfor a briefintervalto new peaks. The timing of the turnaround and thedazzling momentum on the trip back up looked as if St.Sylvester had arranged the whole event. (As noted in the lastissue, St. Sylvester should be the patron saint of the stockmarket: one of his miracles was raising a bull from the dead.)

Once again, those who have argued that investors shouldnever get out of stocks and should buy the dips have beenvindicated in their profitable public adherence to the secularreligion of thefin de siecle.

With each new reaffirmation of the immortality of this bull,the population of public skeptics shrinks. Holding to

The timing of the

turnaround and

the dazzling

momentum on

the trip back up

looked as if St.Sylvester had

arranged the

whole event.


8/29

principles that worked in earlier eras is life-threatening forstrategists.When the Dow broke back through 9,000 a Nesbittbranch manager delivered the classic phrase to me: Whathave you done for me lately?

Fair question.

The Fundamentalists Problem

It is the task of strategists to advise investors on what themarkets are likely to do. A strategist who advises on the basisof what markets should do is interposing his or her ethicalsystem 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: theinstitutional investors task is generally understood to be theachievement of the highest possible returns against definedbenchmarks. Thats why performance numbers are kept andthats why investors flock to the funds with the highestreturns. Stock market fundamentalists have become to mutualfund organizations what Christian fundamentalists are to theRepublican Party: backers of strategies that lose in themarketplace.

What may still be useful is talking about risk-adjusted returns:this market may keep going higher, but it is surely the riskiestmarket since 1973. That doesnt mean it must crash. Thehyperkinetic, hyperbolic Nifty Fifties joyride of 1971-73might have lasted for years more had it not been for

Watergate, the oil boycott, the Great Grain Robbery, and thesudden arrival of stagflation. The market didnt collapse justbecause the Nifty Fifty were absurdly overvalued. It was agloriously extended venture in self-indulgence that requiredunanticipated external shocks to shatter its well-burnished

image of invulnerability and inevitability.

This market is even more self-indulgent, but the enthusiastswho reject valuation models have been right in their New Eraconvictions. Bad news is either minimized by the market ortreated as good news. The party just keeps going on.

page 4

Railing at the

excesses in this

market (which is

becoming a

secret, private

activity, as sexused to be)

misses the

point...


9/29

Theres the story of the New Orleans apartment dwellerwhose infirm mother cannot sleep because of the loud musicfrom a jazz group in the flat below. He goes down and knockson the door. After repeated pounding, the door finally opens,revealing a saxophonist.

Do you know theres an old lady sick upstairs? the soncomplains.

No, man, I dont, but hum a few bars and Ill try is the coolreply.

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

Who worries about hangovers?

From the Exuberant Stageto the Bubble Stage

Alan Greenspan, Pontifex Maximus to this new secularreligion, long ago fretted aloud that the stock market could begripped by irrational exuberance. That is his most-quotedphrase, and it is now quoted not in a spirit of concern, but of

irony.

Basic Points was cautious about equities in 1997, but neverbearish. I suggested that valuations were stretched, but notperilously, given my optimism that inflation and interest rateswould fall deeper than the consensus expected. Real bearmarkets (baby bears, poppa bears and momma bears) hadalways followed rising inventories, rising inflation and risinginterest rates. After the Asian crisis, I turned more cautious,rejecting the Streets consensus that this was merely a small flubug in a group of mini-economies whose collective size wasapproximately 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 thepower of global deflationary forces at a time of fullemployment in the US, I saw no way those estimates could beachieved. Companies other than Microsoft would have little,

page 5

Laissez les

bons temps

rouler!, New

Orleans motto,

is the right

strategy forthis market.


10/29

if any, pricing power, while their wage costs would be rising.Furthermore, I thought that the towering levels of investmentand lending in Asia and the Third World put the globalfinancial system at risk. Bonds were so obviously attractivethat 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 hubrisin this imperious market.

Now I feel like the seer who is told by Julius Caesar, The Idesof 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 near-universal rate cuts) could change the plot decisively strikes meas nave.

The stock market is riskier now than when the Dow firstscaled 9300.

Heres why.

1. S&P earnings have been declining since June and will

continue to fall for several quarters. That means themultiple is rising afteran earnings peak, which is ratherlike raising ticket prices sharply for Titanic six monthsafter the movie is released. At 1166, the S&P is trading at27.1 times a reasonable (if a tad optimistic) forecast of$43.00 in 1999.

2. The first full-blown mania in this long bull market hasappeared. The Internet stocks had been merely a raffishsideshow when the market was moving majestically to9300. Then, in the markets rocket run back to theheavens, the Internet stocks became The Big Story. Unlikepast penny stock extravaganzas, these companies attainmulti-billion-dollar capitalizations within days of theirbirth, long before they achieve earnings. (The onlyrecorded faster growth to full stature was Athenas: shesprang full-formed from Zeuss brow after Hephaestusdelivered the perfect headache remedy; he cured Zeuss

page 6

Then, in the

markets rocket

run back to the

heavens, the

Internet stocks

became The BigStory.


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splitting headache by cleaving his forehead with an axe.Forehead-born, she became the Goddess of Wisdom, aquality not associated with phenomena such as)

EBAY since September 24, 1998

3. The Fed has been forced into the uncomfortable role ofpunch-bowl-replenisher after the party has boiled out ofcontrol. First it organized the Long Term Capital bailouton terms beneficial to the Greenwich speculators (whowould otherwise have had to sell to Warren Buffett at

fire-sale prices). Then it cut rates in dramatic intradayfashion, turning collective financial penitence into thebiggest booze-up in a generation. One for the roadbecame Five for the road. In seeking to de-ice the linesin debt markets, the Fed (ably assisted by the rest of theworlds central bankers) flooded the system with cheapalcohol.The good news is that nobodys talking of a globalfinancial crisis anymore. The really good news (asinterpreted by the markets) is that the Fed is committedto propping up the stock market. Dont fight the Fedhas become The Fed will make us all rich,risk-free.That is not the message the Fed wished to convey, butsomeone who supplies unlimited whiskey and car-keys toa teenage bash should not be surprised if the revelersbehave injudiciously.

page 7

The Fed has

been forced into

the

uncomfortable

role of

punch-bowl-replenisher

after the party

has boiled out

of control.


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Nasdaq Composite Index since August 15, 1998

(A recentWall Street Journalcartoon shows a new fatherhappily embracing his baby. In the maternity ward bed,his wife is saying, I dont care if he was born on a recordday. Were not naming him Nasdaq!)

4. This huge surge in US liquidity comes at a time when USbroad 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 itsannualized 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 forpurchasing securities are up a euphoric 50% year-over-year. The Fed is pumping up asset bubbles at a scary rate.That process is unsustainable.

5. Something else is unsustainable: a negative savings rate.Although economists disagree on the wealth effect, theFed clearly fears that the US will slide into a recession ifa bear market spooks consumers into cutting back onconsumption. The roaring bull market has reinforced thenegative American attitude toward saving. For decades,the US has had the lowest savings rate in the industrialworld. Because consumers have statistical proof that thestock market delivers 20%+ returns forever, they haveresponded by eliminating savings entirely: the personalsavings rate has been negative for two months, somethingthat no industrial country anywhere has achieved (if that

page 8

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!


13/29

is the correct word). The entire consumer sector hasapparently responded to the fashionability of new moviesabout insects to adopt the behavior of grasshoppers in theAesop fable. The last time any major sector in the worldbecame dependent on endless capital gains from stocks

occurred in 1988-89 among the Japanese banks. Thebloated banks real profitability had peaked, but theywere still reporting huge earnings gains on their stockportfolios. The sequel to that collective folly was the re-emergence of something that economists thought wasdead: deflation.

Theres That Word Again

CRB Index since July 1997

Goldman Sachs Index since July 1997

page 9

The entire

consumer sector

has apparently

responded to the

fashionability of

new movies aboutinsects to adopt

the behavior of

grasshoppers in

the Aesop fable.


14/29

Crude Oil Futures since January 1997

Wheat Futures since January 1998

Lean Hogs Futures since July 1997

page 10


15/29

It is time to challenge Sir John Templetons dictum. The fivemost dangerous words in investing are It is different thistime.

Consider:

1. Global money supplies are growing at their fastest rate indecades, yet

2. The CRB Index is at a 21-year low and the GoldmanSachs Index is at a 25-year low, and

3. Long Treasury bond yields are near an alltime low, and

4. The US unemployment rate is near a 25-year low, and

5. The NAPM Price Index is (according to Ed Yardeni)falling at the fastest rate in 50 years, and

6. GDP Deflators have turned negative in several OECDcountries.

What do we think we know from decades of experience?

1. A strong economy produces inflation pressures, and

2. When those pressures become intolerable, the Fed raisesrates, and

3. The Fed lowers rates only when the economy isweakening and unemployment is a serious problem, and

4. If the US and European economies are growing atsatisfactory rates, commodity prices are at least firm, ifnot rising sharply.

What is different this time: the strength of global deflationaryforces. They are overwhelming the cyclical inflationarypressures that should be ubiquitous at a time whenunemployment exists primarily among NBA hotdog vendorsand Republican political operatives.

page 11

It is time to

challenge Sir John

Templetons

dictum.


16/29

Not that inflation is extinct. Nosirree.

For those many economists (such as Stephen Roach of MorganStanley) who have been awaiting inflations return for years,there is finally good news. Those two engines of inflationbiggovernment and big tort law firmshave stepped in. Theirsettlement with the tobacco companies means a 35 cent

increase in the cost of a pack of cigarettes, which will, like somany other government programs, redistribute wealth fromthe undeserving (smokers) to the deserving (lawyers andgovernment) while giving a longed-for boost to the CPI. Ofrabjous day! Calloo! Callay! Other price boosts on cigaretteswill be coming annually, which means tobacco will be makinga positive contribution to the CPI for years.

Deflation has been the principal theme in Basic Points forexactly 24 issues. (Our 1997 forecast, published in December1996, was 1997: The Year of Living Deflatiously. Thisconsistencyor fixationhas annoyed some readers. That wehave stuck to it is not due to primal obstinacy but to ourconviction that deflationary forces would pull overall CPI tolower levels than the consensus expected, which would meanbond yields would fall much below expectations. Initially, weassumed this would be good for stocks, but in recent monthswe fretted that US (and European) stocks might begin toemulate Japan. Since 1990, interest rates in Japan have fallen93%, and stocks (at their low), were down 68%.

US Stocks and bond yields fell together from mid-July to earlyOctober, which gave a distinctly Japanese flavor to Wall Street.Then stocks and bond yields rose together, maintaining thisnew, 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 globalequities, down from 41.5% in 1990. This is an unprecedentedtransformation of relative wealth.

page 12

Not that

inflation is

extinct.

Nosirree.


17/29

page 13

Of course, back then, Japanese stocks collectively were one ofthe twin bubbles that astonished the world, the other beingJapanese real estate. Downtown Tokyos market value wasgreater than the combined value of all non-Japanese real estatein the world. Then the bubble burst. At its low valuation thisyear, commercial real estate in the Land of the Rising Sun wasdown 83% from its high.

Basic Points has discussed the pricking of the Japanese bubbleso often that the details of the story will not be repeated here.

What is worth noting is that Pirandello-style role switchbetween top dog and loser. Nine years ago, the Japanese wereSupermen and the US was entering terminal decline. Now theroles have reversed and so have stock valuations.

I am told that if one deducts Microsoft, Cisco, Dell and Intelfrom Nasdaq, the multiple on the rest of the index is above 90.That puts this symbol of American success at the samemultiple as the Nikkei in 1989,when it was a bubble waitingto be burst.

As readers will recall, I believe that Japan and the US arereciprocals of each other. Japanese save, Americans spend.Japan has more than $1.5 trillion in external assets because ofits endless Current Account surplus, and the US has netexternal liabilities of about $1.5 trillion from its endlessCurrent Account deficit. 1987 was the last time those two

stock markets made powerful bull moves together, and thatflameout was a warning that the experiment must not berepeated. There isnt enough liquidity in the world to pumpup those two mega-markets at once. The over-arching decisionfor all global fund managers is the Japan/US asset allocation.They move funds from one of those markets to the other, andthat process ensures that available liquidity sustains at leastone bull market.

In 1990, Japan was the bubble that had begun to deflate, and

the US was the hard-trying #2 stock market that wasdetermined to catch up. Japanese excess liquidity was a bigpart of that American success story. The overt stage came in1995 with the Reverse Plaza Agreement when Japan devaluedthe yen and single-handedly financed the US fiscal and

What is worth

noting is that

Pirandello-style

role switch

between top dog

and loser.


18/29

Current Account deficits. More recently, the Giant SuckingSound you have heard has been the US sucking in Japaneseliquidity to pump up its bond and stock markets at a timewhen US consumers are spending more than 100% of theirafter-tax incomes.

This national splurge financed by foreign borrowing is a newform of Marshall Plan for Asia and the Third World managedby individual consumers, rather than through national orinternational agencies. The US consumer is the consumer oflast resort. Those Asian and Latin American exportersstruggling with brutal interest rates and sliding domesticeconomies rejoice in Americans willingness to consumebeyond their incomes.

That they can live beyond their apparent means is becausethey actually get richer even as they spend, because their stockportfolios keep appreciating.

The New Paradigm:

1. Asia and Latin America are in serious trouble, andEuropean economic growth is slowing.

2. For all three regions, the key economic dynamic is exports

to the US.

3. Americans can afford to buy more and more of what Asia,Latin America and Europe produce because Americansno longer need to put aside money from their after-taxincomes with their stock portfolios appreciating rapidlyand consistently.

Therefore,

4. If the US stock market enters a genuine bear phase, thewhole world will slide into recession, which means that...

5. All central bankers must continue to supply liquidity tothe US to keep consumer spending up by keeping thestock market up. Whats good for Wall Street is good forMain Street and whats good for Main Street is good forTHE WHOLE WORLD.

page 14

... the Giant

Sucking Sound

you have heard

has been the US

sucking in

Japaneseliquidity to

pump up its

bond and stock

markets...


19/29

Except maybe Iraq and North Korea.

Enter Y2K

The only certain forecast for 1999 is that it will be followedby 2000.

The only certainty about 2000 is that it will arrive amidmassive uncertainty about the basic underpinnings ofcivilization as we known it.

The only certainty about the preparations for computerfunctioning in 2000 is that they will cost more than $800billion. Until witching hour on December 31st, no one willknow 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 withunusual unpredictability during the writing of this essay,involving many visits from Elaine Feldman, our wonderfulcomputer support person. Elaine has been available becausemost of our other computers have been functioning normally.

Whilst I do not suggest any mystical connection between thetheme of this publication and the breakdowns in thecomputer, it is, perhaps, a useful reminder that at yearend

1999 it will matter very much to us all that all the computerson which we rely, directly and indirectly, work at the sametime.

Amid all the hype and debate about Y2K, one fact is clear:whether all the computers work or not at midnight for thismillennium, consumers everywhere are going to be hearing alot 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 goingto put great strains on many consumers confidence. Apartfrom the likely beneficent impact on sales of canned food,wine, guns, and Bibles, the main effect will probably bewidespread uncertainty or fear.

page 15

Apart from the

likely beneficent

impact on sales

of canned food,

wine, guns, and

Bibles, the maineffect will

probably be

widespread

uncertainty or

fear.


20/29

Now, American consumers are impervious to suchconsumption deterrents as negative savings and negative priceincreases. Perhaps they will remain in this splendidlyoptimistic mode right to the Millennium, continuing to tap onforeign 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 thatwould be bad news for Wal-Mart.

And, as we observed, for THE WHOLE WORLD.

What about consumers in less insouciant lands? WillEurolands consumers cut back their already modest spendingif they worry that Y2K will arrive amid disaster?

Fragility

Never has the valuation in the US stock market been sodependent on continuation of the robust US economy. Evenabove-trend growth of 3.8% in the Third Quarter wasntenough to prevent corporate earnings from declining. Itdoesnt bear thinking what would happen to earnings if realgrowth were near-zero.

Never has the US economy been so dependent on the US

stock market. Some part of consumer spending comes fromrealized capital gains. Far more of it comes from consumerswillingness to spend up to and beyond their incomes becausetheir wealth is growing so fast in the stock market.

Never has the valuation in European stock markets been sodependent on continuation of the robust US economy. Suchstrength as Germany displays ( the economy that accounts for33% of Euroland GDP) is in exports, as capital spending andbusiness confidence slide amid growing evidence that the new

government is the most dangerously ideologizedadministration to take power on the Continent since World

War II.

The markets gains are coming from rising multiples on flat orfalling earnings and infinite multiple increases on nonexistentearnings.

page 16

...Americans will

be forced to

increase their

savings and

that would be

bad news forWal-Mart.


21/29

Since it is absolutely crucial that the stock market keepclimbing, 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 youeliminate from the S&Ps down earnings the results from theFinancials, the Oils, and General Motors, earnings wereactually up 9.5%, so the market is actually inexpensive. The

justification for dropping 26% of the market cap of the S&P isthat those earnings hits were one-time events, although nottechnically non-recurring.

What makes this such a breathtaking breakthrough is that hehas extended the Great Discovery of the 1990s into new

territory. During this bull market, the most important newidea was that All Losses are Non-Recurring and All Profits areRecurring. Because of this insight, companies have been ableto grow their reported earnings while admitting to whatwould otherwise be Zantac-inducing losses by closing plantsand firing workers.

Now, we can apply this principle to any reported losses so wenever 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 inAsia and Russia. Who would have believed that an Asiancollapse would lead to a commodity collapse that would leadto a Russian collapse? The Oils were hit by that totallyunforeseeable oil price slump that will never happen again.And General Motors earnings were hit by a strike, which ofcourse could never happen again because General Motors andthe UAW are more in love than Prince Charles and Camilla.Meanwhile, all the wonderful things that happened to theeconomy and the market are mere foretastes of the joys tocome.

It is reassuring to know that we can count on Wall Street forthat kind of thinking when we need it most.

page 17

... because

General Motors

and the UAW are

more in love

than Prince

Charles andCamilla.


22/29

The Clinton Correlation

The linkage between the Presidents approval rating and thestock market meant that Basic Points devoted two issues in1998 to discussing Clintons prospects with reference to thetheatrical form of tragedy.

Mr. Clinton, we noted, has a unique relationship withAmericans hearts. He encapsulates their essential optimism,his color-blindness speaks to their deepest aspirations ofgoodness about race, and his roguishness is captivating,particularly when compared to Republican fuddy-duddies likeBob Dole or the more strident spokesmen of the ChristianRight. He has understood all along that the displacement ofdefined benefit pension plans by 401(k) programs meant that

the majority of voters now cares deeply about the stockmarket. The Dowand particularly the Nasdaqused to beabstract concepts identified with rich Republicans in theminds of most Democratic supporters and manyIndependents.

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 ofthe impeachment hearings. In the real jury to whom Clintonslawyers are appealing, How now, down Dow? is a potentargument for acquittal. At times, his lawyers are almost frankabout the logic of dropping the proceedings so that nofinancially 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 Watergatebreakin, but before the revelations about the White Houseplumbers, Richard Nixon, perhaps the least personallyappealing President to occupy the White House in thiscentury, demolished the Democrats. He won 60.69% of the

page 18

In the real jury

to whom

Clintons

lawyers are

appealing,How

now, downDow? is a

potent

argument for

acquittal.


23/29

popular vote (against a pitiful 37.53% for George McGovern)and took 520 electoral votes to McGoverns 17. As theWashington 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 thecommittees persistence finally led to the smoking gun of thetape. Nixon resigned to avoid impeachment.

In comparison, Mr. Clintons landslide re-election win wasrather modest. He got just 49.7% of the popular vote,compared to 40.7% for the dull Dole, and 379 electoral votesto Doles 159. Even this performance was heavily due,

according to Dick Morris, to the Democrats brilliant andmassive abuse of campaign funds which were supposedlyrestricted to soft uses. Mr. Morris, co-author of this strategy,bragged that Dole was dead before he got the nominationbecause of TV attack ads on medicare, education, and socialsecurity. The Federal Election Commission has confirmed thatthe Democrats did violate the laws, but Janet Reno, the mostloyal Attorney-General since John Mitchell, has given the

White House yet another pass. (The FEC said the Republicansalso broke the laws, but their defense is that they only woke

up to what Clinton was doing late in the campaign, and actedin retaliation. In sports, the player who slugs back when hit isalso penalized for fighting. In politics, two wrongs dont makea right to prosecute either offender, it appears.)

Basic Points argued that Mr. Clinton would probably be forcedto resign, not because of Monica, but because Monica-relatedmendacity would be seen as part of an overall pattern of lyingand stonewalling. Most important, I suggested, would berevelations of the export of sensitive missile technology to theChinese after receipt of illegal campaign contributions fromthat government.

That the Chinese were given sensitive missile technologyagainst the express wishes of the Defense Department andnational security advisors has long been established. That theygot it because Mr. Clinton took away the approval process onsuch technology from Defense and national security agencies

page 19

In politics, two

wrongs dont

make a right to

prosecute either

offender, it

appears.


24/29

and gave it to the deeply politicized Commerce Departmenthas also been established. That Johnny Huang and Charlie Triechanneled illegal funds from the Riadys and other Chineseorganizations to the Democratic National Committee is alsoestablished. Of the many witnesses Congress has sought in its

investigation of this rapidly-developing scandal, few have beenavailable for testimony. Some have skipped to China. Othershave taken the Fifth Amendment. Others, such as formerCommerce Secretary Ron Brown, are dead.

It is part of Clintons amazing luck that in all his scandals, keywitnesses die, disappear, or, like Web Hubbell, stay silent afterreceiving hundreds of thousands of dollars for undisclosedservices. One of the less-remarked aspects of Monicasconversations with Linda Tripp was her warning to Ms. Tripp

that testifying against the President could be dangerous to herhealth.

What should be obvious to even the most embitteredRepublicans is that Americans will not back impeachment ofMr. Clinton as long as the stock market and the economyremain strong, no matter what he has done. Perjury andobstruction of justice could be impeachable offenses if theDow were at 6,000 and the economy were in recession, butnot when everything is going so swimmingly.

As Alan Greenspan noted in July, the American economy is inthe best shape he has seen in a lifetime of watching economicindicators. He was readying the markets for a boost in the FedFunds rate.

Mr. Greenspans earlier optimistic assessment is still shared bymost Americans, although we must assume Mr. Greenspan haschanged his mind.Whats clear is that his drastic policy changeturned a roaring bear market into a roaring bull market in timefor the election.That election seems to have ended chances ofimpeaching 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 weekin a report on a scientific breakthrough. Two scientistsannounced the first decoding of the genome of an animal, amicroscopic worm. Another expert summed up the

page 20

Perjury and

obstruction of

justice could be

impeachable

offenses if the

Dow were at6,000 and the

economy were

in recession, but

not when

everything is

going so

swimmingly.


25/29

significance of this discovery: In the last ten years we havecome to realize humans are more like worms than we everimagined, said Dr. Bruce Alberts of the National Academy ofSciences.

Looking Backward and Forward

The biggest forecasting error I made in 1998 was assumingthat the Asian Plague and global deflation would lead to lowerstock prices.

What really happened was that lower bond yields ignitedNifty 25 stock prices, and lower gasoline and natural gas pricesfueled consumer confidence and consumer spending. As hasbeen noted many times before, a plunge in oil prices acts like

a tax cut in the industrial world. Economic growth in the USand Europe was stronger than I expected because the goodeffects of deflation on prices of foods and fuels more thanoffset the financial uncertainties created by turmoil in Asia,Russia, and Latin America.

I completely failed to predict the boom in technology andInternet stocks. These companies benefited from fallinginterest rates and rising consumer optimism. They werevirtually unaffected by the Russian crisis and only modestly

hurt by turmoil in Latin America. The Internet functionsmostly in English.

Looking forward:

1. I feel confident that technology and Internet stocks willcontinue to lead the market, but assume they will lead itdown. This most speculative of all stock markets cannotforever rely on a consumer economy in which consumersspend more than 100% of their after-tax incomes, relying

on continuation of outsized capital gains.

2. The dollar will continue its slide against the yen and theEurocurrencies, which will encourage foreign investors tocash Wall Street profits and move their funds abroad.

page 21

In the last ten

years we have

come to realize

humans are

more like worms

than we everimagined...


26/29

Europeans were important in driving the mega-cap stocksto the stratosphere. When the Europeans depart, thosestocks 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 veryvulnerable, so the bottoming-out in Asia will not mean anew commodity boom in 1999.

4. Another global financial crisis looks probable, despite allthe easing by all those central bankers. Liquidity certainlyhelps to prevent disaster, but lower interest rates in theG-7 dont make commodity-producing nations goodcredit risks. Commodity prices have fallen much harder

than interest rates, so investors are probably too sanguinethat the Fed can continue its omnipotence. When you arethe central banker of the country with the biggestexternal debt, the lowest domestic savings rate, and themost speculative global stock market, your options arelimited.

page 22

Another global

financial crisis

looks probable,

despite all the

easing by all

those centralbankers.


27/29

page 23

Investment Conclusions

1. Investors should remain heavily overweighted in bondsand should maintain long duration within thoseportfolios. There are two obvious risks in long bondsexcessive money supply growth and a weakening dollar.However, the rewards from deflation continue tooutweigh those risks.

2. Gold continues to shine by being dull. Gold bullionsvolatility has been at the barely perceptible level duringsome of the most tumultuous markets in history. Qualitygold mining shares remain the best haven for resourcestock investors.

3. The next time the attackers ride over the hills, our heroAlan and his trusty men will have a depleted supply ofbullets. If you cant stand violence, you should seek otherhavens than big-cap stocks.

4. The renewed underperformance of US Financial stocksand the widening of the TED Spread suggest that thenext skirmish will come sooner, rather than later. If youare planning on leaving for vacation for the holidayseason, you may wish to leave some stops.

5. The combination of converting for both the Euro andY2K means that European computer systems will bemore stressed than North American. Y2K will be themost-awaited event of our time. Hope for a nonevent, butdont bet heavily on it. The hype could be a severe blowto consumer confidence during a year when thatseemingly unassailable optimism will have plenty else tochew on. Cyclical stocks should continue tounderperform.

6. As interest rates fall, dividends suddenly becomemeaningful. During this long bull market, dividends haveslid into obscurity. Reliable dividends could be the mostbeautiful feature of equity portfolios if the globalsituation continues to deteriorate and US consumers areforced to retrench.

If you cant stand

violence, you

should seek

other havens

than big-cap

stocks


28/29

7. Japanese stocks are joining other Asian markets inestablishing a convincing bottoming pattern. 1999 shouldbe the first year in this decade that Japan outperforms

Wall Street.

page 24

1999 should be

the first year in

this decade that

Japan

outperforms Wall

Street.


29/29

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 JonesHeward 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 datehereof and are subject to change without notice. HIM makes every effort to ensure thatthe contents herein have been complied or derived from sources believed to be reliableand contain information and opinions which are accurate and complete. However, HIMmakes no representation or warranty, express or implied, in respect hereof, takes noresponsibility for any errors and omissions which may be contained herein and accepts noliability whatsoever for any loss arising from any use or reliance on this report or itscontents. 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 oran offer to buy any securities.The Global Asset Managers and their affiliates and respectiveofficers, directors or employees may from time to time acquire, hold or see securitiesmentioned herein as principal or agent. Any of the Global Asset Managers may act asfinancial advisor and/or underwriter for certain of the corporations mentioned herein andmay receive remuneration for same. Each of the Global Asset Managers is a direct orindirect subsidiary of Bank of Montreal.

To US Residents:

Nesbitt Burns Securities Inc., HIM and Harris Trust & Savings Bank accept responsibilityfor the contents herein, subject to the terms as set out above. Any US person wishing toeffect transactions in any security discussed herein should do so through Nesbitt BurnsSecurities Inc..

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