Bill Sterling is Global Strategist for BEA Associates, who are one of the fund managers for C.I. Mutual Funds. His reports are interesting and timely, especially for anyone interested in the larger global picture and how it may affect their investments. See our links page for links to C.I. Mutual Funds and other featured mutual funds.

Charles Dickens comes to mind as I reflect on financial markets in the year just ended. 1997 saw the best of times and the worst of times, depending on where you happened to be invested. Despite higher volatility, booming stock markets were the rule for much of the year in the U.S., Europe, and (at least until the fourth quarter) many emerging markets in Eastern Europe and Latin America. In contrast, Asian markets were generally a disaster, as currency problems and various forms of the Japanese banking disease spread through the region.

I'm also reminded of Dickens while observing how so many investors have developed "Great Expectations" about their equity returns in coming years. In a recent study of 750 U.S. fund investors, for example, respondents anticipated average annual returns on their investments of 34% over the next decade. Not only is this well in excess of what the legendary Warren Buffet has been able to achieve in several decades of extraordinary performance, but it's also roughly three times the average annual return from equities over the last 60 years. Clearly, there is ample room for disappointment here. 

Complacency among U.S. investors does not necessarily portend a bad outcome for the markets in the near term. After all, most investors were complacent a year ago as well. I continue to believe that those who are buying the stock of the world's quality companies today will be the wealthy people a decade from now, though I seriously doubt that I'll be living in a nation full of Warren Buffets.

It's the time of year for fearless forecasts. Keeping in mind the old song lyric that "Free advice costs nothing and it's worth the price", here are a few of my opinions about the year ahead. I'll start with the same question from a year earlier, updated to reflect yet another strong year of returns in the U.S. Q. Aren't you nervous about stock markets after such a strong run in 1995, 1996 and 1997?

A. Of course I am. Valuations were rich in many nations a year ago and, with a few obvious exceptions such as Asia, they are even richer now.

I'm also concerned that the U.S. stock market is basically priced for perfection, with analysts still expecting earnings to rise close to 15% in a low-inflation economy whose growth is expected to slow. In the last few months of the year, for instance, there appears to have been far more upward than downward revisions of earnings forecasts despite the fact that many U.S. industry sectors have significant exposure to Asia.

Moreover, while the whole world is fretting over the potential for deflation, the U.S. labor market is tight as a drum and there are some thoughtful analysts who believe that significant wage inflation is on the horizon if the economy does not cool down fast. Even if firms do not have enough pricing power in the brave new global economy to pass on wage hikes in the form of price hikes, their profit margins could come under considerable pressure if wages accelerate.

The worst-case scenario would be a double whammy: collapsing pricing power due to the Asian recession together with a rapid acceleration in wages triggering Fed rate hikes at home. We think the odds of that scenario are low because the Fed is undoubtedly very reluctant to do anything to worsen the Asian financial crisis. But the bond vigilantes would become extremely agitated at the sight of rapid wage increases and an inactive Fed, and Alan Greenspan might be almost as nervous about the tightening U.S. labor market as he is about events in Asia. Q. Does this mean you're bearish?

A. I would say that I'm reasonably cautious, but not bearish. The drop in U.S. bond yields to below 6% must be viewed as quite supportive both for the economy and the equity markets. As we've noted before, our own study of equity market history suggests that virtually all major bear markets start with a sharp rise in short-term interest rates as the central bank takes the punch bowl away from the party. If that is the case, the Fed's inability to raise interest rates now because of Asia must be considered a bullish factor, at least in the short run. Q. What about international markets? Is Europe's bull market likely to continue? Is it time to buy Asia?

A. As shown nearby, virtually all of the major international markets are valued significantly more cheaply than the U.S. based on measures like price-to-cash earnings or price-to-book value. This was true a year ago and turned out not to matter much as the U.S. market still did very well. But the differences now are even more extreme, and our research shows that these measures have tended to matter over longer periods. Also notable is the fact that even Japan and Asia, which were on the expensive side a year ago, are now at the cheaper end of the spectrum. Of course, cheap markets usually are cheap for good reasons and often get still cheaper. 

Among major international markets, we continue to favor Europe versus Japan for several reasons. First, Europe's growth prospects over the next several years look much more favorable. Second, European corporations are engaged in a restructuring and consolidation wave triggered by the advent of European Monetary Union, which should be a plus for corporate profits. Third, the advent of monetary union is likely to boost capital formation in Europe as European capital markets become more efficient.

My caution on Japan also extends to other markets in Asia as well. While Asian valuations are beginning to look interesting, the outlook for growth and profits over the next year or so has markedly deteriorated. Like Japan, the region faces an overabundance of excess capacity and a credit crunch as banks try to minimize their lending exposure. Moreover, politics in Asia are likely to be extraordinarily tricky over the next year as the economies deteriorate. Despite the recent International Monetary Fund (IMF) bailouts for Korea and other Asian nations, the threat of large-scale corporate debt defaults remains very real if nations find themselves politically unable to live with strict IMF conditions. 

For investors with a time horizon of five years or longer, this might be an interesting time to buy Asian markets. Over the next six to 12 months or so, however, I expect the rough ride to continue. If anything, the Latin American and Eastern European markets might be the first beneficiaries of a stabilization of the situation in Asia in view of their better prospects for corporate earnings growth. As usual, I will be delighted to change my mind if I find that I've misdiagnosed the investment environment. Q. What about our friend, Mr. Bond? How are you positioned in your balanced funds?

A. I was not sufficiently bullish on bonds in the second half of last year and may have missed a bit of the party. With commodity prices dropping and the Asian crisis still on the front burner, quality bonds in the developed nations may still have more room to rally. But as noted above, the Fed has to be concerned about the tight labor conditions in the U.S. and will be quite reluctant to ease policy barring a crisis in the global debt markets. I suspect that the Fed will be happy to sit on its hands for most of this year and count on the Asian slowdown to bring U.S. growth back down to the 2.5% range.

Against this backdrop, I expect the yield on the long U.S. Treasury bond to stay in the 5.5%-6.0% range for most of this year. If the Asian situation worsens, that coupon will probably look more and more comforting. In our balanced funds, we are neither bulls nor bears at the moment. Our current asset allocation target is a very middle-of-the road 60% for equities, 30% for bonds and 10% for cash. Our duration targets also are neutral, since we think that deflation risks are probably overestimated by much of the bond-buying community at this point. WON UP ON WALL STREET

In short, we are positioned for a decent, but not great, year in global markets, but are feeling somewhat more cautious than at any time in the last few years.

The good news is that lots of other investors are worried about the same things and that interest rate trends remain benign. Tens of millions of baby boomers still need something to do with their retirement savings and are unlikely to be satisfied with the current yield on bank deposits. They also are going to be less likely than in recent years to put their money overseas and have to worry about what an overnight dip in the Far East Kamasutra Index will do to their hard-earned savings. So a significant weighting in the U.S. market still makes sense. We leave you with a chart showing some key sentiment factors we will examine as we try to gauge whether the market truly has peaked.

Best wishes for a happy and prosperous New Year.