Since many of you have read quotes in the press such as "the average stock is down 25% from its high" we should discuss why this is occurring. (The average decline of all New York Stock Exchange listed issues selling over $5 is 27.2% as of August 11, according to A.G. Edwards’ research department.) We will also address the question "Should we be worried?"

Three main factors contribute to extended declines in stocks, as opposed to corrections that occur every so often. The three factors are 1) inflation, 2) a decline in the expected return on invested capital, and 3) government proactivity that increases the costs of doing business and/or changes the rules of doing business.

A rise in inflation expectations is the primary factor effecting the price of bonds, stocks, and any other forms of future cash flow streams. If investors worry about inflation, then cash flows coming to them in future years rapidly lose value in today’s dollars. Mathematically, discounting a future cash flow at only a modestly increased rate dramatically reduces its present value. For example, long maturity bonds decline in value and interest rates rise when inflation fear increases.

Increasing interest rates compound the problem by slowing the economy. More dollars go to pay interest expense, and new capital investments lose attractiveness with higher financing rates. The slower economy diminishes the cash generation of companies. Combining lower cash generation with a reduction of the present value of future cash flows leads to a leveraged decline in the value of a business. Since owning a stock is fundamentally the ownership of a corporate cash flow stream, the value of the stock declines in line with the reassessment of the value of the cash flow stream.

Now you see why inflation is so bad for the stock market: It starts a "vicious circle" that causes rates to rise, slows the economy, reduces earnings, and lowers prices investors will pay for cash producing assets, all at the same time.

The good news is that inflation is not a problem now. The slowing of the U.S. manufacturing economy that we talked about in the last letter should cause layoffs late this year and reduce the wage pressures

Alan Greenspan is prudently worried about. The Asian economic recession (will we call it a depression in hindsight?) lowers the competitive consumption of base commodities such as oil and grain, in turn further reducing inflation pressures. Asian problems also contribute to the slowdown of our manufacturing economy. While a slower economy here and very painful economies overseas generate scary newspaper articles, they add longevity to the very positive low inflation investment climate.

The Administration and Congress at this time appear unlikely to do anything that significantly affects the growth rate of businesses, or the rules under which they operate. President Clinton’s current travails temporarily worry the markets, and are unlikely to lead to personnel changes.

The level of world competition to produce goods and services is unprecedented. As noted in the last letter, inventories have grown this year at the fastest pace in history. There is lots of capacity to produce goods in the U.S.; capacity utilization is near 80%. The power of manufacturing companies to increase price is generally feeble. Company managers have trimmed expenses for more than a decade now, and one wonders if "the low hanging fruit" has been picked.

All of this indicates a decline in the level of earnings and return expected on invested capital over the coming five years. As earnings growth projections decline, so does the stock market.

The stock market became overly optimistic about the continuation of the rapid pace of earnings growth experienced over the past several years. It is rational to expect the broad market to adjust to more reasonable expectations. This adjustment explains the correction in the stock market.

Corrections are very hard to time; they just happen. It is usually best just to sit through them and try to ignore them. For those who happen to have cash, they provide wonderful opportunities. All of us wish we could have sold out just before the drop, but that is not realistic. It is just too hard to get the timing right. For example, one could have made a good case for selling out two years ago to wait for a 15% decline. The result would have been sitting out two years of a good market. Selling out a taxable account to avoid dips also can end up costing more in capital gains taxes than just holding on.

We believe this is the beginning of a long period in which companies that succeed in building proprietary business franchises will greatly outperform the market averages. We are ready.

Steven L. Re¢ , CFA

August 11, 1998

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above mentioned securities in their own accounts, and may trade them at any time without notice.