How Low Can the Market Go?
Jude Wanniski
May 9, 2002


Although the market has enjoyed a nice little rally, taking the DJIA back over 10,000 once again, we spend some part of our day at Polyconomics discussing the market bottom for 2002. We have been citing the rise in gold this year to the $300 level as the reason for adjusting the bottom to 9400 from 8500, when gold was $265 early last year.  Because there are all kinds of other factors, negative and positive bearing on the markets, it could go lower than 9400 or higher, depending on how those factors play out. That`s what we kick around. In the main, the consensus is that the pluses and minuses will cancel out and the DJIA will tread water when it hits 9400.

Michael Darda gave us this comment as a starting point. "If the Dow simply reasserted its historic multiple to after-tax corporate profits, the index would have to fall to just over 6,000. The S&P 630 or so. And that`s assuming double-digit rise in post-tax profits this year. Now that`s not going to happen as the market obviously is willing to trade at higher multiples, but even with gold over $300, or at $350 for that matter, I would think that the best we could hope for would be an end to the nominal equity decline as profits slowly play catch up."

The big negative is in the deterioration in the fiscal picture at all levels of government, which we have warned would be an automatic adjunct to the "L-shaped" economic track we are now obviously experiencing. Because there is no economic rebound ahead, there is also no likelihood of a rebound in revenues to the political subdivisions. The federal surplus has been wiped out and triple-digit deficits in the billions loom -- even if the Bush administration finds a way to avoid broadening the war in the Middle East. Of course, in our model, added tax rates at any level subtract from the national economy`s ability to take on new risk, which has helped undo the deflation by weakening the demand for dollars. Dollar liquidity becomes more plentiful relative to gold, pushing up the gold price.

We might also ask, "how high the price of gold can go?" Of course the sky is the limit, if enough mistakes are made. Even this little jump in gold in recent months has "gold bugs" on the Street predicting $1000 an ounce the way Larry Kudlow was predicting a DJIA of 50,000 by 2020 three years ago when it crossed 10,000. In 1982, remember, gold went to $500 from $300 in six or seven months, sweeping the stock indices along in the inflationary updraft. This possibility has always been "on the mind” of the bond market during the deflation process, keeping yields higher than gold and commodity prices would suggest. It is also a factor in the steep price-earnings ratios in the equity market that Darda comments upon. With deflationary pressures off debtors and inflation in the air, the inert liquidity in the system would be unleashed in genuine inventory rebuilding and consumer willingness to spend that we really did not witness in the first quarter.

The revenue effects on state and local governments to date have been having their greatest impact thus far on public-works spending, which has now gone into a fairly sharp decline. When faced with the options of cutting spending on welfare or government employees, raising taxes, or postponing capital spending, politicians put tend to put a hold on the bridge-and road-building projects. This is now showing up in the numbers. As the months go by, though, this option will run down too, and there will be more pressure to raise taxes.

On the positive side, we still have the influence of the elimination of the capital gains tax on primary homes valued at $500,000 or less. There has been almost no attention given to this last gift to homeowners from the Clinton administration, but it takes on greater significance with the rise in the gold price and an eventual end to deflation pressures. By a hipshot guess, this little-noticed provision in the 2000 tax bill wiped out $1 trillion or so of tax liabilities to home-owners -- a transfer of wealth from the federal government to the citizenry. This is the huge pot of gold that has enabled the real estate industry to weather the deflationary storms. Homeowners otherwise under financial pressure can collateralize this wealth to add value to their properties through home-improvement loans, or simply to take on new debt for other purposes. Tax accountants tell me their clients are very much aware of the provision, and upper-income families with two expensive homes -- city and country -- are collecting the gains in one, then shifting primary residence to the other to collect its gains. The higher the gold price, the more valuable this provision becomes to those who own homes of lesser value.

Believe it or not, I do think the farm bill is also a net plus to the economy, as it relieves a farm sector that has been crushed by the monetary deflation over the past five years. Editorial writers for metropolitan newspapers always complain about farmers being the privileged class in being able to get price subsidies from the politicians when they are in trouble. It is important to note that the 1996 “Freedom to Farm Act” that cleared away many of those price subsidies was supported by much of the farm community -- a clear indication farmers prefer free markets when the market is not otherwise being screwed up by the government or the Federal Reserve. I’ve suggested on our website that the $200 billion price tag over 10 years for the farm bill be deducted from Alan Greenspan’s paycheck over the next million years, as it was his monetary deflation that sank nominal farm prices. The funds are a small price to pay to keep farmers and the communities that serve them solvent, able to continue providing the nation’s consumers with a cheap food supply.

The biggest threat to the economy remains the Middle East and the prospect that the President will not be deterred from military action in Iraq. I’m told it is almost certain that the U.S. will invade Iraq, probably commencing in September, but “almost” depends on too many variables to add up to certainty. I’m still optimistic that the drift of administration policy is to be more balanced toward the interests of the Arab League and the Palestinians, as the President is more and more frustrated by the hardline stance of Ariel Sharon. The White House is now putting out the word that the chief reason for taking on Saddam Hussein is to benefit Israel, which has always been the case, but now it becomes open knowledge. This puts an enormous burden on Israel to seriously work toward a Palestinian state that makes political sense, of the kind outlined by the Saudis combined with the features agreed upon by the Palestinians and Israelis at Taba, Egypt, in January 2001. The Republican War Party, centered in the Pentagon and the conservative press, continues to push the White House and Congress to support military action against Baghdad asap, which of course would end all possibility of a peace process over Palestine. The Bush Administration now says it doesn’t matter if Saddam allows the weapons inspectors back in, it still wants Saddam’s scalp. It would be an enormous gamble to proceed, as the Arab League is unified behind Iraq. One thing is sure if the President went ahead. The price of gold would go straight up, and so would the price of oil.