Keep the Faith
By Lawrence Kudlow
After a tough week like the last one, to be nervous is to be human. But, long-term
investors, who are by far the majority of the new Investor Class, should keep their eye
on the favorable long wave trends that are still unfolding in the U.S. economy. And
stay the course.
Historically low inflation and interest rates, moderate tax-rates, a virtually deregulated
economy, an increasingly liberalized global trading system, and a once-in-a-century
technology surge, are themes that will be with us for a good long time. Think of it as
economic freedom powered by the Internet.
The vicious stock market correction now underway will not, in my judgement, continue very long. This is not
the beginning of the end of the long bull market wave of prosperity. Corrections come and go, as they have
many times. But fundamentally, the principal prosperity killers -- double-digit inflation and interest rates,
confiscatory tax-rates, wage- and price-type regulatory controls, and high tariff barriers to trade -- are
nowhere in sight. This is why I remain an optimist.
There are some near term glitches. Stock markets are trying to price in growth-threats such as the degree to
which anti-trust regulatory actions aimed at Microsoft (and possibly other market dominating firms) might
curb technology's role in the economy. Also there is a concern about Internet taxation, which of course
would impact the growth potential of the nascent dot com industry and the whole cyberspace
communications story.
Also tax payments. Though commentators rarely think about it, tax burdens during this prosperity have
increased substantially. Particularly middle-income taxpayers, whose rising real incomes have pushed them
into higher brackets. By some estimates, tax collections this year are rising at an incredible 12% rate
compared to the year earlier. As a result, the FY 2000 budget surplus may come in at $230 billion, about
$50 billion above official government estimates.
From this emerging tax drain, it wouldn't surprise me if a lot of folks had to liquidate stocks in order to meet
their April 15 tax obligations. This is especially true for non-withheld income, which itself is rising partly from
the tax bracket creep effect. And don't forget capital gains accumulated in recent years, which may well
becoming burdensome. Wouldn't it be nice if Congress and the President started returning these surplus
revenues back to the people who earned them in the first place?
Investors are also trying to figure out the future course of Fed policy, and its impact on economic growth
and profits over the next year or so. More than likely the expansion rate and its profitability will slow over the
next eighteen months because the Fed has stubbornly insisted on imposing a speed limit to growth.
So market valuations are being revised lower to reflect this probable development. But we're talking about a
growth slowdown, not a recession. Even if there were a recession, it would likely be mild and short-lived. But
the future economy looks to be moving toward a 2 1/2% to 3% growth horizon over the next eighteen
months. Not an outright recession, but a good deal lower than the 4% growth trend of the past five years. A
25% downshift in growth, however, is capable of forcing a sizable compression of price earnings multiples.
Crucial to the growth outlook is the expected inflation rate. Today's core CPI rise seemed to cause some
panic over this. Actually, the twelve-month core CPI increase in March was really only 2.4%. This is not a
prosperity killer.
The gold price, meanwhile, remains in the $280's and the dollar exchange index is quite strong. True
enough, the Fed injected excess money into financial markets last year, but that liquidity excess is being
removed. So any inflation blip is likely to be short-lived.
Long-term Treasury rates have been declining, a good sign for lower future inflation. Mortgage rates and
corporate bond rates have peaked, and they are showing early signs of following Treasuries lower. This is
good.
There clearly has been a market
shift toward risk aversion, which
is in large part a response to the
anticipated slowdown in
corporate profits and economic
growth. Supply-sider David
Gitlitz points out that the spread
between junk bond yields and
Treasury rates has widened to its
highest levels since just before
the end of the Fed's 1994-95
tightening cycles.
Along with the Joel Klein/
Justice Department/ Thomas
Penfield Jackson assault on
Microsoft, with its implied
regulatory intrusion into
America's most innovative
companies, this would explain
the excessive drop in Nasdaq
stocks.
Also implied in this widening credit spread is the threat of an economywide liquidity squeeze and a mild
credit crunch. Indeed, the possible credit crunch threat and the technology-aimed regulatory threat are
really the two biggest issues out there.
In recent weeks Fed officials have been telling us that their tightening actions were aimed at keeping pace
with the increase in real interest rates, measured as the rise in inflation-indexed Treasury bonds (TIPS) and
real corporate bond yields. But these real interest rates have stopped rising and are beginning to slow down
a bit.
So it is likely that the Fed will be less aggressive, and hence the tightening cycle that began about a year
ago is coming to an end. Given the stability of the dollar's relation to gold, I still don't see why the Fed
needs to tighten any more.
All that said, long-term investors should not forget the spectacular stock market performance of the past five
years. Sometimes in the midst of living in a difficult moment we forget all the good that has occurred before
it. For instance, even including today's sell-off, the Nasdaq index since 1994 has increased in price by
350%. The S&P has expanded by nearly 200%, with the Wilshire 500 and the Dow up over 170%.
These are great numbers. They represent a phenomenal trend of American wealth-creation. And that
wealth-creation itself is a barometer of the free-market economic growth and the fabulous technology
innovation that has rewired and recreated the U.S. economy over the past two decades. Despite some
near-term issues, these long cycle trends remain in place.
Some wise old person once said that when it rains, it pours. Suddenly, folks are concerned about a whiff of
inflation, some overzealous Federal bureaucrats, a frequently opaque Fed and, even, the November
election -- which may well become a referendum on the outlook for free enterprise. But the skies will clear,
and this too will pass.
George W. Bush, an opponent of over-regulation and a strong supporter of free enterprise, has increased his
lead to 8 or 9 percentage points in the most recent polls. If Bush wins, technology regulations will be
restrained. Huge budget surpluses will lead to lower tax-rates. The dollar will remain strong. Trade will
expand.
The overarching theme remains one of strong economic growth powered by the transforming effects of rapid
technological advance. There is more economic freedom in the U.S. than any place in the world. Over the
next decade, that freedom will continue its global spread, powered by the greatest gains in knowledge and
information in history, communicated worldwide at an unbelievably rapid pace.
Stay optimistic. Long-run investing pays off. Keep the faith. Faith is the spirit.
|
