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Issue XVII

September 1998

Sharp Investing

The Bear is Here: Why Smallcaps Will Come out on Top

After preaching for over three years that a bear market was eventually coming, it has finally happened. As I write, the Dow Jones Industrial Average (30 big stocks) is down more than 20% from its July high, and the broad market (about 10,000 stocks) is down 44% from its April high. Make no mistake about it, this is the biggest decline since 1987 and may end up approaching the epic bear market of 1973-1974.

Why? A year ago the world was considered to be a perfect place and economic prosperity around the world was unprecedented. Companies that took advantage of this new global economy saw their stock prices pushed to extreme levels. Levels that were unsustainable.

Then Asia got sick. Then Russia. Then Canada. Then Latin America. It has become increasingly obvious that developing countries with much of their GDP tied to exports are facing a global credit crunch. This has had a domino effect on these developing nations due to their interdependence on exports. On top of this, our President's troubles have simply added to the worldwide uncertainty that exists today.

U.S. manufacturing companies have seen a slowdown in worldwide sales, which has translated to lower profit growth for at least another year. So far the service sector has not been affected, but no one really knows how much the dampening from the rest of the world will hurt our strong domestic economy.

Meanwhile, stocks that had been priced at 25 times earnings were looking at profit growth of only 4%, after three years of close to 20% profit growth. So in May, the high tech companies got hit, June saw the small caps get creamed, and in July and August the big stocks got hit. All the traditional safe havens, gold, real estate, bonds, etc., have failed to provide shelter.

Many short-sighted investors have done two things, both of which will be wrong in the longer run. First of all, they have

bought U.S. Treasuries, which are at a 25 year high and certainly won't provide much in terms of long-term return. Second, in a flight-to-quality, investors have continued to put money into the big-name stocks that were overvalued to start with, such as Coke, Gillette, Proctor & Gamble, etc. (although these now are also starting to come apart). These investors are doing this because in the event that they need to pull their money out quickly, the big blue-chips offer the liquidity to insure that any single investor, no matter how large, will always be able to sell their positions. This is why the biggest stocks are only down 20% in the recent decline, where the rest of the market is down more than twice that amount. Yet how safe is it over the longer run to put money into a company selling at 50 times earnings when those earnings are growing at 4%? Just ask anyone who invested money in the Nifty Fifty stocks in the late 60's how well those investments have held up over the years.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
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Daniel R. Sharp
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Why do I like small cap stocks for the coming decade, even though they have been creamed in the short run? Here is my list:

1. Since 1926, small stocks have returned 12.5% versus 11.0% for bigger stocks.

2. Small cap stocks are at their lowest valuations in over 20 years but still have higher projected future growth rates than big stocks, which are still near their highest valuations in history.

3. Small stocks are more domestically focused than big stocks, which should help for the duration of the world economic crisis.

4. Small stocks historically rebound very strongly out of bear markets.

5. The bear market in small stocks has been overdone and there are many opportunities to pick up beat-up small caps, with no exposure to Asia, for extremely attractive prices.

6. When the money returns to small stocks the prices will rise as fast as they declined when the market went south. Those that wait to see evidence of the rebound will be too late.

7. Investors that can understand the distinction between a strong small business and its current weak stock price will be rewarded in the longer run. Many small companies that have soundly beaten earnings estimates have still seen their stock prices cut in half because of investors fleeing the market in general.

8. Long-term investors with patience will look back on this bear market as an opportunity to pick up small stocks at historically low prices.

Just as things weren't as perfect as assumed last year at this time, they are not as bleak as they appear now. The U.S. and Europe, both strong economies, still comprise more than 50% of world GDP. U.S. exports are a very minor part of our own GDP. Interest rates and inflation are at historic lows. And finally, the Federal Reserve has the tools to avoid a recession by lowering interest rates to reflect the lack of inflation if Greenspan senses a slowdown on the service side.

You never get a chance to buy bargains without some sort of uncertainty, but a 40% firesale on most stocks will prove to more than compensate the long-term investor. And in my opinion, the bulk of the opportunity over the next few years lies in the neglected, battered shares of our smaller businesses here in the U.S.

Gail J. Parker is a Certified Financial Planner and a member of the National Association of Personal Financial Advisors. Gail is also a Fee-Only™ Advisor, meaning she does not receive commissions from products recommended to clients. As a guest columnist, Gail addresses the latest changes to Roth IRAs which complements the January 98 Sharp Investing on the original Roth IRA (Issue 14, available in the archives at Welcome Gail!

by Gail Parker

Need for Immediacy: 1998 is the only year where you can convert an IRA or certain retirement accounts to a Roth account and pay the taxes due over a four year period. Dan's article in the January issue

thoroughly covered the ROTH conversion calculations and rules, but a few changes have happened since, giving investors more choices:

Very Important: Conversions MUST take place prior to December 31, 1998, and the paperwork takes time. There may be a backlog at the end of the year. Getting the papers in just before the end of the year will not make it the responsibility of the broker to process before year end, so if you are going to do it at all, do it now.

A few Changes:

You can establish a Roth by conversion and (this is new) now have the option to pay all the taxes in April 1999. Why would anyone want to do that? If you have sufficient deductions, it might make sense. If you have made a significant charitable contribution this year, or if you are expecting your income to be significantly higher in the coming three years it could be beneficial.

If you have already established a rollover Roth earlier in the year, you may be wishing you had waited since the market has softened and your account may be lower in value now. Congress has passed legislation that allows you to "undo" your conversion, and then to "redo" it before the end of the year if you wish. Currently there are no restrictions on a taxpayer's motivation for the undo/redo feature.

You can convert just a portion of your IRA account. I recommend converting only as much as you can afford to pay the taxes on over the next four years. Unless you are VERY young, a rollover that takes from the IRA funds to pay the taxes is not wise. Remember, you are only allowed new

contributions of $2000 per person into either a Roth or a regular IRA per year, and using some of that money to pay taxes will set you back and can't be made up except through the growth and interest earned later.

Some tips regarding IRAs and Roth accounts.

DON'T roll your IRAs together. You are limited on the number of beneficiaries with normal IRAs, so having several accounts gives you greater planning flexibility. With ROTH IRAs you can have innumerable beneficiaries and they don't have to be paid out according to a schedule determined by the IRS. (The IRS generally doesn't care what you do with them, when you take them, or to whom you leave them, because you will already have paid the taxes, and with no taxes due they just don't care!) They do require that money rolled into a ROTH be maintained for five years, even if you are or reach 59 ½ sooner, so be careful.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

One Final Note:

If you do one thing for your financial future this year, stick $2,000 into a Roth account. It's easy, and you'll have taken advantage of getting that $2000 tucked away for tax-free earnings and withdrawals when you want to retire or just cut back on working.

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