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I don’t know much about Kosovo. Writing that reminds me of the Mark Mobius/Franklin Templeton TV ads which aired before the days of emerging market contagion in the second half of 1998. "Do you know the difference between Slovakia and Slovenia?," the bald headed Yul Brynner look-alike would ask. "You should," came his unanswered reply. He was right of course, although the knowledge of the distinction didn’t help much when the deluge came: both countries tanked together. In the same vein, I should know more about the difference between Kosovo and Serbia, and the reasons behind the current conflict that has engulfed NATO forces and those serving Slobodan Milosevic. It is the only rational way to make an informed decision as to who is right and who is wrong and whether Milosevic is really the modern reincarnation of Adolf Hitler or perhaps just a European version of Manuel Noriega.
When it comes to war, though, I know several things before the horses ever leave the starting gate, or to use the proper metaphor, before the first missile ever leaves its stealth bomber. I write in this case from experience, because I was in Kosovo thirty years ago to the day, although back then they called it Vietnam. I was a twenty-four year old baby-faced naval officer, sailing upriver near the Mekong Delta, delivering a cargo of Navy Seals at dusk and bringing them back to the mothership at dawn. It wasn’t the Vietnam that Senator John McCain experienced, nor was it the same one where 45,000 Americans lost their lives, but it was hazardous duty - about as life threatening as any naval officer outside of a cockpit would experience in those tragic years. I sweated bullets, even if I didn’t fire many, and there was blood on my hands in a figurative if not a literal sense. So I speak from experience when I tell you there are two things I know for sure about the war in Kosovo - or any war for that matter.
First of all, I know that there are two sides to almost every war and that "our" side is not necessarily the "right" side. Granted, the one-sided conflict known as WWII, with history’s justified demonization of Adolf Hitler, stands out as a possible exception, but even then, the German people in their minds were fighting not only for "lebensraum" but for a return of the respect stripped from them at the disastrous Treaty of Versailles. The Japanese similarly had claims of economic aggression against the United States that caused them to believe that an attack on Pearl Harbor was really a defense of their own country. More obvious, of course, was the Vietnam War where history is beginning to conclude that those dominoes Presidents Eisenhower and Kennedy thought were leading to a Communist hegemony in Asia were, in this case at least, visions of Secretaries of State and Secretaries of Defense gone catastrophically awry. It was the highnoon of the Cold War, of course, but history will likely conclude that they (the North Vietnamese) were right and we were wrong, and that 45,000 of my fallen comrades, I’m afraid, did die in vain.
Secondly, I know that there will always be wars. That’s not exactly prophetic, I suppose, but there has always been the hope, especially so in recent years where global economic and political systems appear to have moved closer together, that one last war, one unique idea, one unifying religion or even the tranquilizing dispersion of prosperity itself could prevent future armed conflict. Not a chance. Life and war is a game of choosing sides, and whether the "have-nots" have more than they used to have is rarely relevant. That the "have-nots" have less than the "haves" is the pertinent and perennial point. And to imagine that there will never be sides, be they nationalist, ethnic, religious, or even imaginary, over which men (and now women) choose to fight is to be pollyannaish to the extreme. Granted, there will frequently be those that see the light, as did American conscientious objectors in the Vietnam War, but the masses will always trudge behind in blind obedience to a leader commanding a jingoistic headline. I myself was such a follower in 1969 despite being convinced that the war was a Vietnamese nightmare and an American tragedy in the making. But, instead of turning that boat around in the Mekong Delta, I continued to serve, valuing my GI benefits and my prosperous future over what I knew to be the moral reality. I asked myself then, as I ask myself now – if I couldn’t do it, how could a majority of men and women ever do it? They can’t. I was a moral man, an intelligent man, and I plodded lockstep behind Lyndon Johnson and Richard Nixon in their trek to infamy. If I couldn’t do it, there’ll never be enough pacifists in enough countries to prevent future wars.
Kosovo then, Kosovo now. Kosovo forever.
Next month is PIMCO’s annual Secular Forum and you readers and clients should expect a cornucopia of thoughts on the outlook for interest rates and the strategies that we expect to employ in future months and years. In the meantime, let me offer one parting, though certainly not fatal shot on the state of the U.S. stock market. Two articles in four months (January was the first in an Outlook titled "Two plus Two") might seem a bit of a stretch for a firm and writer devoted almost entirely to fixed-income securities but there promises to be no greater influence on the U.S. economy or perhaps the bond market itself in 1999 than what happens on the corner of Wall Street and Broad.
I have argued for several years now that "stocks" should return 8 - 9 % per year over the next 3-5 years. That wasn’t a bearish forecast nor even a pessimistic one because the prediction was quite close to historical average performance over the past 50 years. Instead, it was a recognition that in a Butler Creek world where interest rates and inflation stop going down, that "stocks" would go up only in tandem with long-term corporate earnings growth. The tripling of P/E ratios from 1981 to the present date, (which was primarily due to declining yields and today’s near nonexistent inflation) could no longer be counted on to push annual equity returns up by 20 - 30 % because interest rates and inflation were, as they say in limbo terms, "as low as they were going to go." That left corporate earnings as the sole remaining driver for stock prices and with historical earnings’ growth having averaged 6 - 7% in this century, it seemed more than reasonable, perhaps even optimistic to suggest the stock market would increase by 8 - 9% per annum through the first few years of the 21st century.
Well the new millennium isn’t here just yet and "stocks," when you consider broader averages such as the Wilshire 5000 have actually come quite close to that forecast, but a more realistic appraisal would probably suggest that the market has been much more "exuberant" than I ever expected, and that bonds are bonds and stocks are stocks and never the twain shall meet - especially in Newport Beach, California. Perhaps? There’s no doubt that portfolio managers, yours truly included, have inbred prejudices that almost perpetually bias them to favor their own product and to "dis" the opposition. Still the two are linked inextricably at the hip: stocks are financed at current interest rates; bonds provide a reduced return yet lower risk alternative to stocks; the prices of each usually move up and down together; both are affected similarly by the changing dynamics of inflation; and so on and so on. Therefore it stands to reason that a bond guy and a bond firm should have an opinion on the stock market and vice versa - especially so in 1999 because of the extreme, volatile nature of stock prices and the effect they’re having on consumer spending patterns and economic strength.
So what gives? Have we really entered a permanent new era of prosperity where 20% annual returns are the given, and on-line traders make hay, not at working but at letting money work for them? I suspect not, although there are strong arguments including those from Alan Greenspan himself to support the thesis of higher levels of productivity growth due to technological innovation. That argument is a partial explanation for recent stock market advances because it suggests that if productivity growth continues to increase at higher than historic rates, then corporate earnings will as well; and that if technological innovation helps to smooth inflationary demand side pressures, then the "riskiness" of stocks may be reduced in the future and higher P/Es are more than justified. Even accepting those arguments, however (the permanency of which is dubious at best) the critical blank left to fill in is $ : how much are you willing to pay for it? What P/E do you afford a New Age stock market in a 21st century economy?
The battle to fill in the blank is most obvious with the internet stocks, those "bluest" of new age blue chips. Few of them are profitable or even suggest they will be any time soon, so price/earnings multiples -even price/sales ratios are near meaningless. Instead investors are betting on an industry to come, confident that at least some of the players will turn out to be the next Haloid Xerox or IBM. That the combined portfolio of internet stocks is now worth more than all of the listed automobile, chemical, food, and airline stocks combined doesn’t seem to strike them as odd. It only reinforces their gusto for the future of the industry.
Similar circular illogic is applied to the market itself, especially to those large-cap stocks where growth in earnings seems assured - if only because of accounting gimmickry that mesmerizes and sedates professional analysts who know better but refuse to sound the alarm for fear of losing their half a million dollar jobs in much the same spirit as yours truly drove that boat of Navy Seals up the Mekong Delta. The higher the P/E in these large cap stocks, the more the confidence in the New Age. Why else would so many intelligent people be willing to pay those prices they ask themselves reflectively? And so confidence begets confidence and greed begets greed until one day the investment community realizes that while their new emperors may indeed have clothes, that the wardrobe contains some mighty overpriced rags as well. That day however, lies sometime in the future. Does it intuitively, though, make sense to you that the top two largest cap stocks in the S&P 500 are valued at more than all 2000 companies in the Russell 2000? Does is intuitively make sense to you that the market value of all U.S. stocks combined as shown in the chart below are priced at more than all of the rest of the stocks in the world? How can that be when our GDP is a little more than 25% of global economic output?
Capitalization Of World Markets, 1999 Figure 1
Source: FT-Actuaries, World Markets Monthly, Goldman Sachs
Only if our economy is so much more productive, so much more open and innovative, and/or so much more secure and impervious to economic and physical attack than the rest of the world.
The phrase " so much," of course begets the same question as the one asked in preceding paragraphs - " how much?" There certainly should be a premium for U.S. stocks because our economy is the envy of the world as we approach the 21st century. Investors, however, should not forget that there are two sides to every argument just like there are two sides to every war. Only ten years ago, Japan was the envy of the world and their stock market was at its pinnacle. Now the tables are reversed. U.S. investors banking on 20% returns from their domestic stocks might more reasonably look offshore - to Japan for instance - because prices there are low not high, and the Japanese economy one day promises to right itself and resume its role in global economic growth. Death, war and taxes may be permanent, but a day trader’s right to retire before 40 is not. U.S. investors, especially those in large-cap and internet stocks should prepare to be disappointed.
William H. Gross Managing Director
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