Bear Slide, When Does It End?
Jude Wanniski
December 15, 2000


DEFLATION: If there are no counter forces to the deflationary drag on the markets, the gold price of $270 suggests a nominal Dow Jones Industrial Average of 7500. The implication is of course a deep recession, which is how nominal wages will catch up with nominal earnings. A monetary recession is different than a fiscal recession, such as one caused by higher taxes or tariffs, in that the value of assets retain their purchasing power. In other words, $7,500 buys as much as $10,000 did before the adjustment. There is another positive benefit in that there is a smaller tax wedge as the deflation carries earnings and wages down the progressive tax scale. If your net worth was $10 million before the monetary adjustment and is $7.5 million, it is really the same, although you feel 25% poorer. Thanks for small favors. It still is a very painful adjustment, especially to workers and enterprises who have debts in cheap dollars that they must service with expensive dollars. Workers do not like to take pay cuts. This part of the deflation adjustment has yet to be felt, but will have to be unless the price of gold can be pushed above at least $300, where it was at the beginning of the year. The NASDAQ adjustment is all the more painful because its product is being sold into an economy going through the painful adjustment.

ADJUSTMENT: When the monetary inflation began in 1967, after President Johnson closed the London gold pool, long-term interest rates began their rise and then came price rises. Even those of you who were children in that era can recall how candy bars began to shrink, as candy makers attempted to hold the line at a dime for a Hershey bar. As the inflation process continued an adjustment to gold rising to $140 per ounce in 1973 from $35 in 1967, candy makers had to raise prices of the smaller candy bars. They also came out with jumbo candy bars at five times the old price, all in an attempt to fool customers into thinking they were getting value. At a higher level, the world’s oil producers, who could not shrink the size of a barrel of oil, in one leap quadrupled oil prices, to $12 from $3. What is happening now is the reverse of that process. Candy makers will increase the size of their candy bars before they cut nominal prices. Discounts galore will show up in shopping malls. At some point soon, manufacturers actually will cut nominal prices ahead of their competitors. Oil-producing nations already are finding prices falling. A monetary recession in 2001 would adjust prices further toward oil’s traditional relationship with gold at $270, but in a painful way via a reduction in demand. If the gold price rose above $300, the oil price would not have that far to fall, and the oil industry would be more energetic in developing product for a global economy that had avoided recession.

TREASURY: To get gold above $300 will require a policy change at the Federal Reserve -- and personnel is policy. Our best sources tell us Treasury remains wide open, that President-elect Bush has not yet indicated any preference and awaits a vetting process. The only man on the short list who understands the monetary deflation well enough to work with Fed Chairman Alan Greenspan to change policy is Wayne Angell, chief economist of Bear Stearns. Jack Kemp of Empower America met with Vice President-elect Dick Cheney last Saturday and made a pitch for Angell. Reports from reliable sources since then indicate Angell is in fact under serious consideration, the only negative being that at 70 he may be “too old,” which obviously comes from someone who has not met him. Odds at the moment favor Jack Hennessy of CreditSuisse/First Boston, whom Bush knows and likes. If Hennessy is tapped, we would then have to hope that he would bring a deputy who totally understands the economics of deflation -- perhaps David Malpass, who is Angell’s director of international economics at Bear Stearns.

BONDS: The economic weakness showing up across the board, especially the disappointing Christmas sales, almost certainly will produce a series of interest-rate cuts going into the new year. We are pleased with our late October bond call, which was based on the outlook for continued deflation. Remember the consensus on Wall Street was that a Bush victory would be bad for bonds because his tax cuts would dry up revenues needed to buy back long-term bonds, an idea we rejected on its face. In this environment, bonds should continue to strengthen at least until the time when the Fed begins cutting the funds rate. We’ll reassess then.

TAXES: Speaker of the House Denny Hastert would like to break tax legislation into bite-size pieces when the 107th Congress convenes -- instead of taking up the Bush $1.3 trillion bundle. He is exactly right. With Republicans controlling both the executive and legislative branches, it makes most sense to send up the pieces that already have been negotiated with Democrats in the outgoing 106th Congress and have Democratic support -- the estate-tax repeal, the Roth IRA expansion, and the marriage-tax penalty. The Bush administration thereby could show quick bipartisan success, win favor with the national electorate, meanwhile gathering itself for broader across-the-board reforms. We still are fairly confident Rep. Phil Crane of Illinois will be the new House Ways&Means chairman, Crane being the best of the three in the running.

TAX SELLING: There is downward pressure on the markets, especially the NASDAQ stocks, because of year-end tax-loss selling, as is widely noted. There also is pressure coming from selling related to options at the alternative minimum tax (AMT). John Roemer of The Standard, the weekly report on legal intelligence related to the web, points out in the 12/11 issue that the AMT is killing the New Economy folks who had made killings on their options. He writes, “Consider as an example, the case of a network engineer at a Palo Alto, Calif., startup: He exercised his option to buy 25,000 shares of his company's stock early this year when it was trading at $50 per share. By May, the stock had soared to $200 per share, placing the value of his holdings at $5 million. But his euphoria over being a multimillionaire was cut short when he learned that even if the stock's worth plunged, he would have to pay the alternative minimum tax, or AMT, on the difference between what he spent to buy the shares and $1.25 million, the stock's value at purchase. Unfortunately for the network engineer, by last week, the stock traded at $20. If he continues to hold the stock, now valued at $500,000, he'll owe hundreds of thousands of dollars in taxes.” The drop in the market on/about December 1 may have been related to the interaction of the 30-day wash rule and the AMT on stock options. This is analogous to our call in March on the April tax-related sell off. Folks sold December 1 in order to regain their positions in January -- when the capgains tax rate declined for long-term holdings while avoiding the AMT on stock options that had declined during the year. According to Jerry Spector, a Silicon Valley accountant, the only way around the problem is to sell the stock this year and pay the taxes. In the above example, the engineer is at least left with $280,000. “There are a lot of people out there who will be underwater unless they sell their stock by December 29,” the last trading day of 2000. Thanks to Spence Reibman of Georgia State University for bringing this to our attention.