ANNUAL REPORT

30 June 1997

Investment Manager's Report

Performance
The performance for the year can be viewed as comprising two distinct halves. The first half, which we discussed at length in the interim report, highlighted the culmination of poor outcomes of decisions taken during the previous year and which resulted in some losses. The second half showed a significant improvement with the company's assets appreciating in excess of 19%. Taking the year as a whole though, the pre-tax return of 15.9% is short of the 28% gained by the Morgan Stanley Capital International Index.

PCL Cumulative Performance Of NAV (Pre-Tax) And Share Price Versus

MSCI World Accumulation Index
We are not, however, discouraged by this under performance as it was achieved while following our distinct investment style which we regard as risk averse. This involves buying companies, which for transient reasons, are trading at valuations that are below their inherent business value; by avoiding over priced momentum driven stocks; and by investing for absolute returns rather than seeking refuge in relative performance alone. (Sadly, the momentum element of these markets has taken its toll on many global funds with the average manager in the Micropal Survey achieving similar returns to ourselves, with the damage being done by the explosion of prices in June, notably in the US, where most managers have been underweight.)

When we look behind the bland figures to evaluate the constituent decisions made in building a portfolio, we take comfort from the underlying pattern. In Japan for example, against a market that retreated through the year, we have made some handsome profits, and in Europe we are seeing our stock picking methodology work well. The cost of hedging the US portfolio is evident. However, we have difficulty reconciling the valuations of the leading stocks in that market with the reality as we know it and have sought protection in the belief that adverse price action in Wall Street will have a negative affect on markets elsewhere. (By our measures, some of the momentum-driven big names look to be overvalued by 50% or more. For reasons that we describe in an article in the back of this report, this can continue for a while but has more to do with market psychology than inherent business value).

Changes To The Portfolio
As you will see, we continue to find interesting companies in North East Asia. In the last quarter, we have added a blend of domestic orientated and export sensitive stocks in Japan such as Japan Tobacco, Asahi Breweries; Kyocera, Shimano and Toshiba. In Korea, we have continued to add to Samsung Electronics and have introduced Samsung Fire & Marine. We have re-entered the Indian market taking a position in ICICI (a provider of long term finance) and VSNL (the international Telecoms carrier). Further investments have been made in Siemens and we have introduced Rinascente in Italy (one of the country's largest retail chains, principally hypermarkets and supermarkets). At the same time, we have reduced our holdings in those companies where the values have accelerated past their longer terms norms.

You will notice that we have withdrawn from our Russian investment, the Firebird Fund. This has proved a most successful venture giving us a return of some 169% over 2.75 years. The thinking behind this decision relates to the inflexible nature of such a vehicle as to applications and redemptions, and we believe it will serve our interests better by either investing direct or through a publicly listed investment fund. (Though the Russian market has got itself very excited for the moment, we are still long term believers in the potential of that country).

Top Ten Holdings (as at 30 June 1997)

Stock	Country	Industry	% Holding
Fuji Photo Film	Japan	Photographic Equipment	4.6%
Yamanouchi Pharm.	Japan	Pharmaceutical	3.9%
Schindler	Switzerland	Construction	3.5%
Samsung Electronics	Korea	Electronics	3.4%
Daiichi Pharm.	Japan	Pharmaceutical	3.3%
Siemens	Germany	Electrical Engineering	2.7%
Swiss Industrial Group	Switzerland	Packaging/Engineering	2.5%
Canon	Japan	Office Equipment	2.5%
Lagardere	France	Media/Defence	2.5%
Nintendo	Japan	Home Entertainment	2.4%
TOTAL			31.3%

Disposition Of Assets

Region	30 June 1997	30 June 1996
Western Europe	31.9%	25.7%
Japan	31.8%	31.0%
Other Asia	11.0%	9.5%
South America	5.6%	5.2%
North America	2.9%	14.5%
Australia	1.1%	3.4%
Cash	15.7%	10.7%

Currencies
With continuing uncertainty over the timing and structure of European Monetary Union (EMU), we have removed the hedge on our Deutsche Mark and Swiss Franc holdings but continue to hedge the bulk of our French Franc exposure. Italian Lire is fully hedged reflecting the assymetric risk of holding this currency (regarding its possible exclusion from EMU). We own Sterling given its macro fundamentals and at around 74.5 cents, we are looking for lower levels to increase our Australian dollar hedge.

Australian Dollar 45% Pounds Sterling 4%

Japanese Yen 14% French Franc 1%

Deutsche Mark 8% Italian Lira 0%

Swiss Franc 8% US Dollar related assets 20%

Market Commentary
The markets continue to soar in the world of Goldilocks (economic activity that is not so fast as to create inflation problems and higher interest rates, and yet fast enough for companies to achieve profit growth). As noted in previous commentary, the headwind of restructuring and fiscal rectitude is retarding the recovery in Japan and Western Europe. However, the benefits of cheap money are coming through and growth is apparent on the broadening front. Aiding matters further is the relative calm in currency markets which have allowed Japan and Europe to maintain the competitive advantage their currencies have gained against the dollar starting in mid-1995. The dream run of moderation in the United States continues with the Federal Reserve Board apparently unwilling to pre-empt a rise in inflation with the emphasis seemingly having shifted to a more reactive stance. The concern about asset price inflation has not diminished but in terms of its political brief, the Fed is focusing on consumer price inflation for now.

This "ideal environment" of slow if stodgy growth has however been at a cost to some of the tiger economies of the Pacific. Most notable is Thailand which has long feasted on a rich diet of heavy inward investment and low cost short term money. It now finds itself losing competitiveness and as the economy has slowed, servicing this debt is proving burdensome.

The Korean economy, with its high dependence on world trade, has also suffered from an over-investing binge but its relatively low dependence on external capital flows protects it from many external pressures. It is starting to see the benefits of accelerating exports and falling imports, particularly of investment related items.

The general wash of events that has overshadowed the Pacific Basin region has passed Hong Kong unscathed. It is continuing to benefit from the relatively low cost of money (related to its fixed exchange rate to the US dollar) which together with a booming hinterland, is creating unrealistic expectations in its property market (a little apartment on the Island without views would now cost around US$1 million).

Indonesia is receiving more favourable commentary now that the elections are out of the way. The managed float of the currency has given the Central Bank a degree of control over monetary policy. This combined with the migration of manufacturing from its higher cost northern neighbours, is permitting the economy to grow strongly without undue inflation pressures.

The search for yield is greatly benefiting Latin America. Foreign buyers of traded securities and the flow of direct investment is acting to reinforce the reforms that have been in place for some while now. Corporate borrowers have moved with alacrity to lock in relatively low fixed term borrowings with quality names being able to raise loans paying barely 2.5-3% more than the US Government.

The big event in Western Europe has been the election of socialist governments in both the UK and France. In the case of Britain, the policies of the new government look like having little adverse effect on the established pattern. The decision to give greater independence to the Bank of England and the emphasis of the Government's first budget suggest that the new regime is following orthodox economic policies. The electoral decision by the French population has resulted in a coalition of socialists and communists and is reminiscent of the Mitterrand era of 1981. The initial utterances indicate a high degree of government intervention and a slowdown of reform. However, it seems unlikely that France can by itself resist the prevailing global pressure to reduce State intervention in the economy. As far as its immediate affect on European Monetary Union, it is clear that fiscal discipline will be treated as a lower priority. The prospects are surely now for a broad and flat grouping rather than a deep and narrow model that seemed probable only recently.

The case for our position on specific stocks in Japan has been thoroughly covered in correspondence over the last eighteen months. The positive price action reaffirms our stated views.

Outlook
The positive forces that have been driving stock markets are still intact.

The lack of price pressure caused by abundant capacity should continue to encourage Central Banks in most of Continental Europe and Japan to maintain easy money conditions. The lessons learned from the US model, and which is now something of a reference point, is that the reordering of the linkages within an economy should produce a relatively long and gradual recovery which is very different from the inflation-prone cycles of the Seventies and Eighties. (The ability of the US to tap significant resources on its borders - Mexico and Canada plus the requisitioning of imports further afield aided by a strong currency, do make comparisons a little uneven but nevertheless the big surprise in this environment has been from the supply side.) Even as growth synchronises, cost pressures in the laggards (Japan and mainland Europe) will be held in abeyance by virtue of still under-utilised resources. The likely pattern is that the leaders within the cycle will continue to raise rates ahead of the others and hence interest rate differentials should widen.

The US economy is surprisingly robust given the duration of the current economic upswing. The market is predominately focused on the idea that the low level of unemployment poses a threat to the current level of relative price stability. It is evident that the financial market boom is creating a virtuous circle of confidence and expenditure yet it would be wise to monitor signs of economic weakness. Credit card delinquencies are exceedingly high and durable good sales and orders have stalled.

Enhancing the general feeling of well being in the US is the notion that we are entering a period of greater economic stability on the back of the information technology revolution and that the American model, which looked rather dowdy in the mid-eighties, has now come into its own. The belief that the "business cycle is dead" may have a short life but for the moment it is a popular view. The unusual convergence of events which stem from significant and protracted currency cycles which have unleashed a whole galaxy of sub-events, or which have coincided with such events, should not be misinterpreted as a new economic paradigm. After all, at the macro level, Asia has just demonstrated errors of expectations with a super investment cycle; the micro-chip industry has had a similar binge and nowhere is there better evidence of the vitality and exuberance of crowd behaviour than the current headlong charge into equities.

With most of the indicators suggesting relative price stability, the bets must be with the Fed being reactive rather than proactive notwithstanding its concerns about asset price inflation. In this environment, valuations of stocks will play second fiddle to the tidal wave of money that is seeking higher returns.

The realisation that supply side changes have shifted the level of inflation back to that last seen in the late Fifties and early Sixties, has added another leg to the bull market. The folklore built around the threat of upward racheting levels of inflation during the Seventies and Eighties, has taken a long time to dispel. The problem now facing investors is that their cash deposits are earning seemingly meagre returns at a time when they observe others capitalising on the rising valuation of long duration assets (especially equities). We are now entering an environment where the stock market is creating its own folklore involving the open vistas of opportunity available to multi-nationals and the selective evidence that equities always produce superior returns through time. So long as the competition for these funds remains low, and there are no exogenous shocks, the compulsion to own equities will grow.

As usual, despite our caution, we are concentrating on the areas where there is some value and maintaining an element of protection through cash and derivatives.

Stock Stories

Swiss Industrial Group (SIG) (Switzerland)
Most of us probably know Tetra-Pak's Brik-Paks, which are used to hold fruit juices, long life milk, soups and stock for a variety of producers. The secret of the Tetra Brik-Pak boxes is layers of foil, polyethylene and cardboard which create packaging that stops light, air and bacteria from corrupting the contents. Combined with quick heat treatment of the contents, this allows for long life storage without refrigeration or the addition of preservatives. The process is known as aseptic packaging.

A name you may not know is PKL. PKL, with their Combibloc product, are the only real competitor to Tetra in aseptic packaging. Interestingly, PKL invented the original aseptic packaging process, sold the technology to Tetra, then later, realising their misjudgement, developed a new process that circumvented the earlier patents.

Aseptic packaging is technically difficult. The machines produced by PKL have to take a packaging blank, fold it, glue the sides, snap heat the container and the liquid (in a clean air environment) as filling takes place and then seal the package. PKL's machines can do this 12,000 times per hour. The technical difficulty of the process, the patent protection and the dominance of the major player have ensured the aseptic packaging market remains a duopoly. This in turn has allowed it to become a very profitable business. However, what makes this a great business is not the machines but the packaging blanks. Once you own a PKL packaging machine you need the pre-formed blanks to feed into it. The only company that may supply these is PKL. The customers are locked in. Every new PKL client represents a long term stable flow of very profitable revenue.

PKL was purchased by SIG in 1989 and it has flourished under the new owners who have been willing to spend money on expanding the business and have encouraged innovation. These innovations have included the introduction of two litre containers, easy to open tops, resealable lids, faster filling speeds and more flexible carton lines. Around 70 billion aseptic packages are consumed each year of which PKL accounts for 7 billion. Historically the market has grown at 6-8% pa and strong growth in Asia and Latin America (where refrigeration is a luxury) suggest that this growth rate is sustainable. PKL should grow faster than the market as they gradually take share from Tetra Pak.

PKL has become steadily more important to SIG and today accounts for 60% of sales and we suspect almost all of operating profits. The remaining 40% of sales are divided between SIG packaging technology which produces machines for more conventional packaging and SIG Neuhausen which is a mixture of businesses including small arms and mechanical drives and automation equipment. A management change in late 1996 is leading to active restructuring of these businesses and those that don't earn an adequate return on capital are likely to be sold.

When we first started buying SIG, the negative news surrounding the stock related to the strength of the Swiss currency and the company's apparent dependence on engineering. Even the then little known PKL was under pressure on account of a sharp rise in pulp and plastic prices. We subsequently added to the holding after a change in ownership in Tetra Pak which we believed would lead to better pricing in the industry and again as it became clear that changes in SIG's management were putting more emphasis on extending the packaging business. The share has nearly doubled since our first entry point (April 1995), but we still see it having significant upside potential as people catch on to the importance of the high recurrent income stream generated by the Combibloc.

Asahi Breweries (Japan)
Asahi Breweries is one of Japan's great corporate success stories. Its share of the Japanese beer market has risen from a lowly 10% in 1986 to 34% today and rising. These huge gains have been the result of the stunning success of its "Super Dry" brand launched in 1987 when dry beers became popular worldwide. Asahi people relate the story of a struggling minor player hitting upon a beer with a sharp and refreshing taste that appealed to Japanese tastes and especially the younger generation. They then used slick marketing campaigns revolving around the theme that "dry" signifies "he means business!" This was highly effective against stodgy existing beer advertisements that emphasised traditional themes. Their banner advertisement was an endorsement by a popular writer of spy novels.

The fact that Asahi's initial success survived a loss of enthusiasm for dry beers and the company has gone from strength to strength can be put down to the quality of management. Asahi appears to have been able to identify with the changing aspirations of the consumer market. One of its most important breakthroughs was to foster new distribution channels which have allowed it to circumvent the market dominance of the traditional leader (Kirin). Today, the company is well established among the discount liquor and convenience stores that have usurped the traditional mom and pop delivery service. As a result the company's market share in places like Tokyo is over 40%. Even with its success, the company maintains a youthful enthusiasm derived from its former status as the underdog to Kirin.

The lure of the bubble economy proved too great for the company and it, along with many other corporates, was sucked into the mélèe of the late 80's bubble. The subsequent losses and poor reported results masked the remarkable improvement in underlying profitability that is associated with the benefits of scale. As this suppression falls away with completion of the write-offs, core profitability will start to show through and be appreciated by the market. In addition, the company has taken some actions which we would view as positive. These include repurchases of stock, moves toward instituting stock options for management and sales of non-core assets, the most significant of which was the sale of their stake in Fosters.

So in essence we have a company that is growing its core earnings at 15% per year with a much improved balance sheet and actions that appear likely to enhance shareholder returns. On an earnings yield of 4.8% compared with a long term bond of under 3%, the market seems to be mispricing the company, especially when considering the growth potential. Despite anticipated faster growth and the lower discount rate in Japan, Asahi enjoys no premium in valuation to its international peer group.

Chairman's Report

Investment Performance
The Net Asset Value of Platinum Capital Limited grew by 11.7% last year after allowing for all tax liabilities, both realised and unrealised. On a pre-tax basis the growth figure was 15.9%.

By way of comparison, these performance figures are better than last year, but not as good as the appreciation in the Morgan Stanley Capital World Accumulation (Net Return) Index in A$ (MSCI) which is often used as a benchmark for the performance of international investment funds.

The table below sets out the performance for Platinum Capital in each of the three years of its operation and compares these figures to the MSCI. The total cumulative return to investors over the three years is also shown.

PCL PRE-TAX NAV VERSUS MSCI %	1994/95	1995/96	1996/97	3-Year Cumulative
PCL	13.0	12.2	15.9	47.0
MSCI	14.1	6.7	28.5	56.3

Platinum Capital's performance in each of the three years has been fairly consistent and, taking a long-term view, is very much within the sort of return parameters that can be expected from equity investment. The MSCI over that time has been more varied and is ahead both this year and over the three years. This is in large measure due to the index's heavy weighting in the US equity market, a weighting which is not reflected in Platinum's portfolio. The Investment Manager discusses the reasons for Platinum's approach more fully in its report.

In assessing Platinum's performance we consider it to be reasonable, but below our aspirations. Over time it is still our goal to offer good returns and to outperform the MSCI.

Share Price
The share price movement has continued to be fairly volatile and, in common with many listed investment companies, does not fully reflect the underlying value of the company.

In an effort to address this issue last year we sought and won shareholder approval to buy back up to 20% of the issued capital of the company in a year rather than the 10% allowed under the Corporations Law.

The intention was that if the share price went to a substantial discount to NAV it would be in the interest of all shareholders to, in effect, invest in our own stock by buying it back.

On 3 March 1997, the company announced it would seek to buy back up to five million shares and more recently on 19 June 1997, the buy-back period was extended for a further six months to 19 December 1997.

To date, no shares have been purchased under this arrangement because the discount to NAV has never been sufficiently large.

Whether the share buy-back announcement has had any effect in limiting the discount is hard to tell, but the company considers the power to buy up to 20% of its capital may be useful in the future and a resolution to that effect is on the agenda for the Annual General Meeting.

Dividends
The company's dividend policy is to make relatively modest regular dividends which can be built up over time. In addition, an occasional special dividend might be declared to pass on accumulated franking credits. The total of these credits prior to recommended dividend was 21.4 cents at 30 June 1997.

This year, Directors are recommending an increased regular dividend of 3.0 cents per share (last year 2 cents per share).

The issue of how best to pass on accumulated franking credits is still under discussion. A significant number of Platinum shareholders are New Zealand residents and discussions are currently in progress between the Australian and New Zealand Governments on issues such as double taxation.

We have decided to take no further action in this area for the time being in the hope that new arrangements will emerge such that special dividends will be less disadvantageous for our New Zealand shareholders.

Outlook For 1997/98
The overall outlook for the world economy and for many of the important national economies within it is somewhere between positive and benign. The economic fundamentals of low inflation, readily available money, moderate and synchronised growth underpinned by productivity gains from technology and restructuring are about as good as things get. To an investor the issue is value: how do you buy value in markets whose valuations largely reflect all the positive factors with little margin for any negative news?

Platinum will continue to assiduously seek value rather than just go with the flow of money. At times this will put us out of step with the received wisdom. Over the longer term, it remains our view that this approach has a better chance of producing superior returns for shareholders.

Special Report On The US Equities Market

Introduction
Bull or bear markets can endure for a surprising amount of time, as the persistence of direction is caused by the extremes of human behaviour.

The longer the cycle is in place, the more the actions of the participants extend it.

US Equities Market
The bewildering rise of world stockmarkets and of Wall Street in particular, is generating a great deal of excitement but increasingly is causing an equal amount of anxiety. To try to give our shareholders some sort of framework with which to analyse the behaviour of markets, we have outlined some of the forces at work that are lifting prices of shares to record highs.

The essay focuses on US equities and takes a closer look at the rolling reallocation of resources through the economic system in a way where the beneficiaries change through time. Starting in the early Eighties when the great fight against high inflation was finally won, we have witnessed an extraordinary reallocation of resources away from the providers of labour to the owners of equities. This has resulted in the total return from equity ownership being almost twice that of the historic average in this century.

The unusual feature of this cycle is the confluence of events. Major distortions in currency markets, the opening up of new markets and resources, great strides in the application and power of technology and so forth, have caused some to question whether we face a new and utopian economic order. Our article deals with some of these issues and concludes that international corporatism and other features of today's economic landscape are merely passing scenes in the scheme of the economic cycle.

The danger of the current super bull market turning into a fully fledged mania is real. Some may even point to the excesses (for instance, change in corporate ownership via options, massive flows into mutual funds etc) as evidence of some markets already being afflicted by a mania. Weak growth and still concentrated liquidity is such that low yields on cash deposits are "forcing" investors to take more risk to augment returns. The seductive mirage of the new information age, with its capitalist white knight finally defeating the evil empire of collective ownership, is a powerful stimulant to investors' inclination to greed.

When one reads the history of manias, the recurrent pattern over the centuries is very clear. The markers include an abundance of credit; a new exciting world of change; the emergence of financial cult figures and so forth. As fund managers we are torn between following a fundamental approach and yet being sufficiently agile to recognise the unfolding pattern. History is a valuable guide but, sadly, only provides a crude street map without any indication of scale.

To alert readers to the possibilities of what may lie ahead, we have illustrated our text with quotes from J K Galbraith's classic, "The Great Crash of 1929".

US Equities
The bull market in US equities is in its fifteenth year, and over that period it has delivered a cumulative return that exceeds the bull markets in the US of equivalent duration that ended in 1929 and 1957, and the bubble which peaked in 1989 in Japan. Since the beginning of 1995, the 100% return from the US market compares to 33% from 30 year bonds, 32% from the world stock market excluding the US, 10% from residential housing in America, and 10% from cash. The only stock markets to outperform the US over the last two and a half years have been Russia, Spain and Sweden.

So what has been going on and how do we make sense of it? The bull market in equities that began in 1982 can best be explained by changes in relative prices. Traditional economics divides the economy into three constituencies: labour, natural resources, and capital. By capital we mean the productive assets of the economy, which we can also think of as the corporate sector. In the last thirty years, each component of the economy has experienced imbalances in supply and demand that has caused it to be bid up in price (both absolutely and relative to the other sectors).

From the mid 1960s through to the late 1970s, with unemployment at low levels, the scarcity of labour allowed it to command higher rewards at the expense of those employing the labour, thus transferring wealth from capital, or the corporate sector, to labour. In the Seventies, commodity prices boomed as a result of a weak world grain harvest and fears of general supply shortages. At the same time restrictions in the supply of oil and gas drove energy prices up dramatically. The US had a legacy of expansionary monetary policy to finance the Vietnam war and this provided the fuel for an extraordinary era for natural resource owners. From the early 1970s through to the early 1980s, they were the winners at the expense of capital, which now had to pay more for their inputs. Labour also began to suffer as wages failed to match other price rises.

The imbalances which cause price rises in one sector do not continue in perpetuity because of adjustment mechanisms that come into play. The shift of labour intensive industry to developing countries meant unskilled labour in the developed world had to compete with cheaper overseas workers, forcing it to price itself more cheaply. Similarly, increased exploration of oil and more efficient oil consumption served as the release valve for the pressures in the energy market.

From the mid 1960s to the early 1980s, while the labour force and then natural resource owners were being enriched, productive assets provided poor real returns. This was reflected in the poor returns on the instruments used to finance these assets:- in fact, the US equity market was essentially flat for a sixteen year period from 1966 to 1982. Businesses responded to this by cutting back their spending on new plant and equipment. The reduction in the supply of productive assets led to an improvement in returns on capital, which was reinforced by the reduction in excess returns to labour and resources. This can be seen from the following chart.

* Corporate profits expressed as a % of GDP.

The improvement in corporate profitability has been accentuated by a succession of interrelated events that, while not restricted to the US, have been of more significance to that economy than elsewhere. Productivity growth, government shrinkage (and lower tax rates), a weak currency, consolidation, deregulation, brand premiums and particularly lower interest costs, have helped US companies increase earnings by 100% since 1992, which compares with only 68% growth in German profits and a 39% increase in UK profits.

The very strong dollar in the first half of the 1980s reduced the competitiveness of American industry, resulting in a collapse in exports. The corporate sector responded by engineering a significant improvement in productivity which, with the help of a depreciating currency, drove exports as a percent of GDP from 7% in 1985 to 11.5% today.

Productivity growth itself has had a second wave, driven by the enthusiastic adoption of information technology in the US, where the level of usage of PCs and the internet far exceeds that of other nations. Innovation has occurred broadly where for example improvements in seismic technology, imaging systems and data processing have lowered the cost of finding and producing a barrel of oil by 30% in just the last four years. These and other techniques to streamline processes has greatly benefited the manufacturing industry which consequently has been able to cut inventories 9% so far this decade, freeing up $82 billion of capital.

American companies have generally embraced globalisation more enthusiastically than most European companies, which have been hindered by the distraction of European integration and domestic recessions. With their improved competitiveness, US corporates have been able to compete successfully in overseas markets against less efficient and less aggressive locals.

As the private sector tends to utilise resources more efficiently than the government sector, the reduction in the relative size of the government over the last decade has had a positive effect on the efficiency of the economy. An important part of this has been the reduction in the defence budget since the end of the Cold War, freeing up $240 billion or 3% of GDP. Similarly, deregulation of telecommunications, air travel and power have made these industries more efficient and helped suppress inflation.

The process of consolidation, and the movement away from the conglomerate structure so popular a decade ago, has created businesses operating in fewer industries but with a larger share of their core markets. Facilitated by a less interventionist regulatory authority, this concentration of markets, has improved returns in many industries, such as banking, defence and aerospace, oil refining, and broadcasting.

It is observable that brands are today able to command a greater price premium, and a greater share of their market, than they have for a long time, and hence earn supernormal returns for their shareholders. How is it that adding a "Swoosh" logo turns a $5 T-shirt into one sold to willing buyers for $50, and is an Intel processor really worth twice as much as its technical equivalent from AMD? The answer to the puzzle must be a behavioural one. Perhaps because of the effect on confidence of corporate downsizing, "tribalism", or common behaviour, is a very powerful force. Brands provide instant acceptability - no one is considered "uncool" wearing a Nike shirt and drinking Coke - and this acceptability makes the purchase decision an easy one. In developing markets, where people want to associate with American success, these brands have aspirational qualities. The US is a big beneficiary of this tribalism phenomenon as the domicile of many of the world's leading consumer brands:- Nike, Coke, Gillette, Marlboro, Compaq, Microsoft, Intel, Johnson and Johnson, Campbell's Soup, Disney, Barbie, Colgate, etc.

Returns to capital have expanded over the past fifteen years, so why haven't we seen corporates more enthusiastically adding to their capital base to take advantage of this prosperity; part of the adjustment process that would then work to erode these returns? The high degree of focus in the US on shareholder wealth has meant that despite returns on productive assets being very high, and the cost of financing low, there has been a great reluctance to create excess supply by aggressively adding capital. Executive compensation is now so closely tied to share price performance that management aims may have changed. Could it be that management is more concerned with reporting current profits than accumulating long term wealth for the company? Do all the layoffs and all the industry consolidation make for stronger corporations in the long term?

Part of the bull market in equities has been the improving returns to capital, or corporations. The other driver has been the way in which those returns are valued by investors. Share prices have risen because of the secular reduction in consumer price inflation. Why should this be so?

Firstly, when prices are rising rapidly, the depreciation which companies record as a cost to their earnings is much less than the cash they must outlay to maintain and replace their assets. To compensate for the overstatement of earnings, the market attributes a lower value to the reported earnings than when inflation is low. The second dimension to this is that corporates pay tax on artificially high earnings.

Secondly, a lower discount rate makes future cash flows more valuable today. It is for this reason that a decline in inflation has a more favourable effect on the valuation of a stream of cash flows that is growing, than one that is not. Hence, the cumulative performance of equities during this bull market has dramatically outpaced that of other asset classes and, within the equity market, growth stocks have been the strongest performers. Recently, the "Nifty Fifty" type of stock (in both the US and elsewhere) has been revalued based upon the perception of near endless, riskless growth in an environment of scarce growth because corporates can no longer rely upon product price increases.

Low inflation also has important effects on the stability of the economy. The absence of rapidly rising prices greatly improves the confidence businesses have in investing and hiring people:- in fact, in their whole decision making process. Since 1983, there have been only four quarters of declining GDP, compared to twelve in the prior decade. This stability has been helped, no doubt, by few exogenous shocks such as wars. A more stable economic environment is in fact a less risky one, so the extra return investors require to invest in traditionally risky assets such as shares declines, and the prices of these assets are bid up. Many have extrapolated current trends to suggest that the business cycle has ended and the chances of a recession have been substantially eliminated by new management techniques and the opening up of the economies in Asia and Eastern Europe. Why has this not happened before as forecast or more importantly, has there been some fundamental change in human behaviour?

Another important factor in the revaluation of financial assets has been the effect of low short interest rates. Individuals tend to respond more to nominal rates than real rates. For instance, they feel that money market rates have become much less attractive as they have fallen from, say, 10% to 5%. This could be an "inflation illusion", for the reality is that their real return after tax is actually much better. Therefore, the fall in short rates has encouraged people to shift savings into bond and equity mutual funds, as shown in the following chart.

The effect of lower short rates in pushing savings into long duration assets in search of higher returns has been amplified by events in Japan. Following the bursting of the bubble in Japanese asset prices in 1990, interest rates have been reduced to extremely low levels to stimulate economic activity and reinflate asset prices in order to bail the banking system out of its bad debt problems. The Japanese economy has continued to create liquidity through their strong trade performance, but the unattractive domestic interest rates have encouraged these funds to be invested offshore, resulting in a mass of Japanese money purchasing US bonds. This has increased the price of these bonds, leading to higher equity prices. The important point is that the flow of Japanese money to the US, which underpins US financial asset prices, originates from a crisis in the currency and the economy, most particularly the banking sector. Similarly, European rates have been kept low to stimulate activity and improve the competitiveness of the export sector through weaker currencies.

If the forces of falling inflation and robust corporate earnings growth have been driving the market strongly for several years, what can account for the largest nine week gain in market history over the April to mid-June period? Inflation and earnings have continually bettered expectations, but it has been the increasing degree of conviction in the continuation of these factors that has driven the recent acceleration in the stock market. When a theme or force has been in place long enough, it comes to be perceived as being perpetual.

The expressions "new era" and "new paradigm" have been used a great deal in the last year or so, and the idea that we are in fact in a new world is a seductive one. The US has indeed achieved a great deal economically over the last five years. Since the beginning of 1992, the federal deficit has been reduced from 5% of GDP to 1%, economic growth has been double that of Japan and 75% greater than Europe, the crime rate has been reduced, and despite corporate restructuring, 13.7 million new jobs have been created. Unemployment of 5% compares to 12% for the European Union. Ironically, the only G7 country currently satisfying the European Maastricht criteria is the US. But does the IT revolution have a greater impact on the productive capacity of the economy than did the railroad, the electric motor, the assembly line, the telephone or the jet airliner? Despite improved competitiveness and the benefits of free-trade with Canada and Mexico, America's trade balance hasn't improved, the gap between rich and poor is wider than ever, consumers are indebted to a greater extent than ever, and a social security problem of huge proportions exists on the horizon. How should we best measure prosperity and progress anyway?

Evidence of infatuation with the stock market abounds. US corporates often judge the performance of their management by that of their stock price, and dramatic rises in executive compensation have gone unchallenged and often bear no relation to the performance of the business. Individuals talk of the stock market as a vehicle for making money, forgetting that "Wall Street is one way only if you are driving a car", let alone that financial assets are simply a claim on the income producing potential of real assets.

One of the features of financial markets is the brevity of its memory. It is only ten years ago that the death of US manufacturing at the hands of the all-powerful Japanese was widely predicted. Similarly, while the US labour force is indeed flexible and fluid, it is only two decades ago that wages were settled according to CPI expectations. And while government today is highly accommodative to business, it has not always been so docile; recall the break-up of Standard Oil and AT&T and the imposition of Prohibition. Should we believe in the perpetuation of the favourable environment we have today, when we have witnessed change of such scale? In the future, will commentators marvel at the good fortune of companies which have been allowed to corner their markets - such as Boeing taking over McDonnell-Douglas and defence companies merging to effectively limit competition for lucrative contracts?

Within this market psychology can be identified the same distortions and belief patterns that have existed in the advanced stages of other asset price cycles. During the 'tulip mania' that immersed Holland in 1636, a "single bulb of previously no apparent worth might be exchanged for a new carriage, two grey horses, and a complete harness". In favour of loans to the growing railroad industry, it was questioned "who could lose on what was so obviously needed". Similarly, banks in the US nearly went bankrupt lending heavily to Latin American countries in the 1980s - how ridiculous to suggest that these fast growing economic wonders would have trouble repaying their debt. Similar crowd behaviour was exhibited by the rush to invest and build plants in China during 1994-95. The accepted wisdom was that you simply had to be there. How often did we hear "if every person in China consumed but one ....."? The reality has been heavy losses by the majority of players, and one European packaging company has recently walked away from a $100 million investment. There is great attraction in being with the crowd, and questioning of what is perceived to be obvious, is unwelcome. An old Japanese folk saying that was popular when that market was soaring in the late 1980s, is "the fools are dancing, but the even bigger fools are watching". More recently, US senators berated the US Federal Reserve Chairman, Alan Greenspan, for his precautionary comments, such as suggestions of "irrational exuberance" in the market.

We are in an environment where the market has recognised lower inflation and is now demonstrating an increasing appetite for risk. This is reflected in lower premiums for risk on the debt of emerging market countries such as Russia and Brazil, and US "junk" bonds. As the appetite for long duration assets becomes overwhelming, the premiums investors require to hold these risk assets will be lowered, driving prices of bonds, and particularly equities, to even higher levels. While we may well get a serious correction before the bull run comes to an end, the market's learned response from the last fifteen years (including 1987!) is to buy the pullbacks.

The final phase of the bull run is likely to be a narrow blow-off of the multinational growth stocks, or "new Nifty-Fifties". Even though the corporate environment may have deteriorated, investors will cling to the belief in the infallibility of equities (or, at least, selected equities). Remember how Gold held up remarkably well after US interest rates were increased in the early Eighties, and yet investors kept thinking that a fall in the price of gold represented a buying opportunity. There are many similar historical examples indicating that crowd psychology changes more slowly than one would expect.

What could bring this bull market to an end? Historical corporate behaviour would suggest that at some point, the chase for market share and subsequent price erosion, or new innovations will erode profitability. Alternatively, foreign companies may build plants in the US to take advantage of market openings or pricing umbrellas and be prepared to accept a lower return of invested capital in order to participate in that economy. Exchange rates could also fluctuate significantly to set up yet another cycle.

Financial asset inflation has begun to spill-over into the real economy. In the last year, some parts of the US have seen rises of about 30% in prices of commercial real estate, the upper end of the residential housing market and even farm prices. House prices in London, Boston and Sydney have all moved up smartly. Leakage into real spending is likely to follow, as higher real estate prices attract building and renovation, and this money is recycled through the economy. Central banks in the affected economies would be forced to respond to this by raising rates, despite product-price inflation remaining benign, and Greenspan has alluded to this on more than one occasion. Activity in Japan and Europe is likely to pick up in the next year, and the absorption of liquidity will tighten monetary conditions. The US economy's growth rate could revive, leading interest rates higher. Few expect the signs of weakness in demand to become more pronounced but this is also possible (not everyone has participated in the financial asset boom; many are struggling to meet their debt repayments despite very low interest rates). If it is not, the real economy will undoubtedly suffer given the widespread participation by small investors in markets that have thus far only been kind to them.

The economy has to continue to walk this narrow line - buoyed by leakages and yet restrained by moderate income growth and high consumer indebtedness - for this bull market to be sustained. As the market continues to advance, the intertwining of the market and the economy becomes more dangerous.

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