We can take pleasure in Wall Street’s soaring market today, cheered by Greenspan’s tight-fisted munificence and the likelihood of a Bush presidency. For NASDAQ, though, the respite may be just another in the New Economy’s relentless march of one step forward, two steps back. Wall Street “wisdom” now certifies the boom was based on mindless speculation or mindless momentum investing, that the markets were wrong all along. We, however, continue to believe the boom was built around deep discounting into a continually expanding world economy. That’s the only way P/E ratios can climb into the stratosphere as they did, rising and falling abruptly as the market questioned the world growth path over a long stretch of years and decided it would be between 2-3.5%. Those kinds of growth numbers are fine for the Old Economy, but when you deep discount, you have to have numbers at least at the top of that range in order to have the Old Economy buying from the New at fancy P/E’s. Mike Churchill, who heads our global sector, sent me this memo over the weekend, positing a polar view, a worst-case scenario, just for the heck of it. It is worth thinking about:
If we don’t get material tax cuts, and if gold doesn’t rise, it is now at least hypothetically possible to conceive of NASDAQ at 1,500 and a DJIA at 5,000. That probably won’t happen, but one can see easily how it might. A look at 20-year charts for key Dow and NASDAQ stocks shows in mind-boggling fashion how far up this stuff has gone -- 1,000 percent on average. Much of that rise was due to the monetary stabilization that began in the early 1980s. The key postulation for a market plunge is this: A 30% deflation does not just have a 30% negative impact on profits, it often has a 100%-plus negative impact on profits. If a company’s sales remain constant in gold terms from 1997 to the present, by definition its dollar sales have fallen by 30%. If the profit margin was 10% of sales in 1997, it now would be -20% of sales. That EASILY takes a stock’s value down 75%, and usually more.
This is precisely what happened to companies tied directly to commodities, and it already has worked its way pretty far up the food chain. Early casualties were low valued-added products (auto parts and tire companies being great examples). DuPont is an interesting recent casualty, down 50% in two years. Now we’re clearly into computers. Gateway is down almost precisely 75% from its peak three months ago. Of course, companies have been expanding sales in gold terms since 1997 and also improving productivity, so it is not at all obvious or necessary that we to go back to 5,000 and 1,500. However, it also seems that it would not be too difficult for the indices to go even lower, particularly given the sick policy paradigms of most emerging markets, which undermine the global economy.
We continue to find resistance to our deflation argument among many clients. The most persistent is the argument that if the economy slows, the demand for liquidity will decline and the surplus in the system will cause a rise in gold, ending the deflation. That would be nice if it happened, taking pressure off dollar debtors and allowing them to pay their creditors. On its face, though, this scenario requires a decline in the real economy to a range inhospitable to the New Economy stocks. In addition, there is no reason to believe a slower economy will cause a rise in the gold price, even with the Fed lowering the funds rate. When the Fed worried about inflation in 1993-94, raising the funds rate six times to combat it, the price of gold did not budge. If it now worries about a weak economy and begins a cycle of lowering rates, the economy would improve, but not necessarily with a rise in the gold price. That would require an addition to reserves over and above the amount being demanded by the banks. The Fed’s operating mechanism is not compatible with this process. As the Fed was “tightening” in 1993-94, the demand for funds was rising, which meant the Fed actually had to add liquidity to hit its target. Now, as the Fed tries “easing,” the demand for funds will fall, requiring the Fed to subtract liquidity to hit the target. It will be a net plus for the overall economy, which is why Wall Street cheers, but hardly an end to the deflation. Remember, Japan has had no luck ending its deflation by lowering its funds rate to almost zero. The yen-gold price has decreased steadily as the Bank of Japan drained reserves in order to hit its targets. There are no visible signs of intelligence in Tokyo anymore, their Keynesian model producing the world’s lowest interest rates, strongest currency, and the biggest budget deficits -- the equivalent of an $800 billion deficit here.
Gold did run up $10 in the last few trading sessions to $275, but now has eased back to $273. The first place we look in our analytical model is the tax realm. If the market sees tax cuts in the lame-duck session, the demand for liquidity rises at the margin. If it thinks the session will prove fruitless, the gold price will rise, as demand for liquidity shrinks at the margin. This is no better for NASDAQ and the high-tech world. When we have monetary policy checking fiscal policy and vice versa, we have to project long-term growth rates at low levels. We still do not have a good fix on what kind of legislation will come out of Congress as President Clinton demands more spending than GOP leaders want -- and Republicans note the imminence of a Bush victory and argue for a postponement of tax cuts until next year. The tax changes in the pending legislation are not only top-drawer in their supply-side impact, but they also come out of surplus projections that will soon be increased to a higher plateau, tempting higher spending. “We need to get this money out of town as fast as we can,” says a Washington supply-sider.
Mike Churchill’s worst-case scenario with a NASDAQ of 1500 is really only possible if policymakers in both parties remain brain dead to this deflationary paradox. Fed Chairman Alan Greenspan is not much help. In his comments today, he identifies the increased risks the market now faces as a result of feedback effects of “the 1998 financial crisis,” caused by unknown forces as far as he is concerned -- when it was his own refusal to equate the collapse of gold as a sure sign of a commodity world starved for dollar liquidity. It is always possible for him to segue into a more promising analytical track, substituting a commodity target for the Phillips Curve that has held him in its grip since 1997. He may have to be nudged by a Treasury Secretary in a Bush administration who will not be cowed by him. There is a report Governor Bush is thinking about a Democrat in that spot, which is not a bad idea if it is Felix G. Rohatyn, the wisest of all Democratic financiers, lately of Lazard Freres, now our Ambassador to France. (I have written my website memo today to George W. about Felix.) There are, after all, a lot of smart people around who could do wonders for the U.S. and world economy if they were willing to serve in a Bush administration and were asked to serve. Bush’s first two picks we know about for sure, Dick Cheney as VP and Colin Powell as Secretary of State, were as good as it gets. We now are holding our breath on the top Treasury slots.