At the beginning of every year, there is a brief change in the risk structure of the U.S. economy due to the vagaries of tax law. In a monetary deflation, these are all positive, as we have explained umpteen times in recent years. Workers who maxed out on their $2,000 Roth IRAs in 2001 can now max out again, this year up to $3,000. Then there is an automatic upward shift in the minimum standard deduction and all tax brackets because of the CPI increase for 2001. The 2001 CPI was exaggerated because the Bureau of Labor statisticians look at sticker prices on autos and big-ticket household goods to calculate the inflation rate, not examining the huge discounts offered. Capital gains are deflated as well, which means a lower effective capgains tax. And as the work force adjusts to new jobs at the margin, their paychecks will be nominally lower this taxable year. In addition, there are the teeny positive changes in the tax rates this year, the first phase-in of last year’s tax legislation.
These “January effects” are huffing and puffing to keep the Dow Jones Industrials above 10,000, but they simply are not muscular enough to offset the continuing drag of deflation. The successful conversion to the euro does add another positive effect. And because the euro has averted the monetary deflation, which makes it look weak relative to the dollar and yen, it provides some muscle to the world’s economic outlook for the year. For that reason, even though Wall Street will head lower, we see equity markets in Euroland at least holding their own in 2002, with the best chances for gains in Germany and Italy. Argentina has finally escaped the dollar`s clutches, and if the new government does not go too far in the opposite direction, it could remove a serious drag on the Latin American economy. We have recommended a peso re-pegged at 1.25 to the dollar, the equivalent of gold at $350 at the one-to-one rate, not the expected 1.4. In Asia, Japan is inching away from the clutches of its own yen deflation, causing heartburn in China, which remains pegged to the U.S. dollar. South Korea and Malaysia still look like better bets to us as they do seem to know what they are doing. Russia seems the best bet of all for another solid year of advance in its markets and its economy.
On Wall Street, it should not be long before the January effects are over and with them the continuing correction to gold’s signal. I have asked the Poly staff for pros and cons. Here is an interesting internal e-mail exchange that I pass on, as it catches the flavor of our analytics:
MIKE DARDA: The S&P Technology Sector is trading at 43 times 12 month forward 2002 earnings estimates. At twice the S&P market multiple, the tech group is exchanging hands at valuations not seen since March 2000, right before the tech wreck.
MIKE CHURCHILL: Agree, although it is getting tedious to sit around and talk about how stupid the market must be as it goes up every day. Either this is another 2000 (where “common sense” carries the day) or we’re wildly wrong. I think we’re right, but I’ve been thinking of ways we might be wrong. Some possibilities: 1) Europe is doing a really good job at fiscal and monetary policy and will lead the world out of recession, with the help of east Europe and Russia; 2) China and Southeast Asia are doing a good job at fiscal and monetary policy and will become the factor at the margin that carries the global economy forward; 3) Intense cost-cutting by top U.S. firms will allow profitability to exceed the estimates we’re putting out; 4) In general, it is the case that Europe and Asia are doing pretty decent things with policy and it is chiefly the U.S. (one-third the global economy) that is doing poorly. Many U.S. firms are multinationals that could sell overseas even as the U.S. economy remains weak. This COULD explain tech going up while other things don’t. For my money, I would not buy this hypothesis and instead would stick with the idea that tech will go down. Yet, it’s a possibility.
DARDA: All valid points. It’s one hell of an uncomfortable position to be in. I think if one bets against the market 10 times, one will lose most of those bets. In 2001 we bet against the market in January, May and October. We were right in January and May. The October rally was just a bit higher than we thought was probable under current macro conditions. I don’t see how earnings can turn up as dramatically as would need to be the case to justify broad equity prices unless we’re wildly wrong about the deflation adjustment, e.g. pricing power/earnings in 2002. That is of course a possibility. In that case, the market’s right, we’re wrong, and the Fed will be trying to restrain growth with rate hikes by June at the latest.
CHURCHILL: I would be more concerned if ALL THE DATA DIDN’T BACK UP OUR POSITION. Just this morning there was a funny event: Merrill Lynch upgraded Dow Chemical to strong buy from buy. Two seconds later Dow announced that it would miss its fourth quarter estimate because market conditions remain weak. A perfect example of reality not doing what analysts keep wanting it to do. Also, new jobless claims were out this morning -- way above expectations. And the car companies are hinting that they are going to have to continue piling on huge incentives in 2002 to move product. Bottom line: the deflation remains inexorable. You can’t escape its logic. Tech is probably getting a bounce because pricing for chips over-adjusted to the downside by so much that it has to RISE to equilibrate. It’s doing just that. Doesn’t mean any of those companies are going to make a nickel, though.
DARDA: Here are my pros and cons. First the bad: 1) Deflation in the US/Japan/UK; 2) Full-point jump in market interest rates from November on, due to the FOMC’s speed-limit economic model; 3) Weakness in global $/GDP growth. On the good side: 1) Fed funds no longer at growth-stifling levels of mid-2000/early 2001; 2) Oil back to equilibrium with gold; 3) Bush tax cuts, while weak, phasing in by 2006; 4) Russia/China implementing supply-side policies; 5) Asian tigers running good monetary policy and cutting tax rates aggressively; 6) ECB not deflating, Europe still shaving tax rates; 7) Political risks down since September 11, but could change with invasion of Iraq or another outburst of terrorism.
CHURCHILL: Agree on all those and add my own. Bad: Tax policies in several key emerging markets -- Mexico, Brazil, Argentina, Turkey; Russia’s crawling peg monetary policy; Japan’s currency weakness may engender an inappropriate currency-weakening response from its neighbors; Rising systemic risk in Japan; Also rising risk in U.S. banks; U.S. high-yield debt; U.S. state-tax rates likely to rise substantially in 2002, 2003, 2004. Good: Sharp cost-cutting by top U.S. firms; Increasing corporate efficiencies gained via use of technology, and internet-based procurement (purchasing inputs by net); Little sub-optimal capital allocation going on.
One positive I still carry around with me is the prospect that as news comes in that there is no “bottom” just ahead and no “rebound” in sight, the Bush administration will look for a way to correct for the deflation. In 2001, I thought this process would begin in September, but then September 11 confused all the pictures. Bad things happen. But there are also happy surprises now and then. Murphy’s Law is not immutable.