A year ago today, we thought the Dow Jones Industrial Average would get as high as 7800 this year, that the long bond would get to 6%, and that the dollar/yen rate would get to 130. The numbers were not the result of dart board throws, but had extensive political and economic analysis appended. The most important was the assumption that 1997 would produce a cut in the capital gains tax because of the way the national elections turned out in November 1996. As an extension of this bet, we assumed there would be an increase in the demand for dollar liquidity, and this would cause the price of gold to fall to $350, which would be impressive enough to cause the long bond to go to 6% from almost 7%. Then, if Japan could get enough relief from its deflation to push the yen price of gold to Y44,000 per ounce, the dollar yen rate would wind up at 130, higher than any of the 50 noted economists predicted in the January 2 edition of the WSJournal. (Edward Yardeni of Deutsche Morgan Grenfell came closest with 128).
We hit the Trifecta, although not as neatly and cleanly as we’d hoped. We never imagined we would hit the dollar/yen rate by having the Bank of Japan so intimidated by the Clinton Treasury that it would follow the dollar/gold deflation below $300. In other words, if we had predicted the Nikkei a year ago, which we did not, we would have been wildly wrong. Consistent with the numbers we did forecast, the Nikkei would have been above 22000 instead of scraping 14000. There, our error is entirely based on our misreading of Fed Chairman Alan Greenspan, who we believed would respond to the dollar/gold deflation when gold got below $340. He did not and the Asian central banks followed him to the gates of their present hell.
Greenspan now moves to the top of the list of variables that provide the material for our 1998 forecast. We can’t count on him as we have in the inflation years. This means we can’t be as bullish as we were at the outset of 1995, 1996 and 1997. (When you are told that nobody forecast the 20% rise of the Dow Jones Industrial Average in each of three years running, please mention Polyconomics.) This does not mean that we believe the bull market has come to an end, but that unless Greenspan corrects for the dollar deflation by cutting the federal funds rate at the earliest opportunity this year, it will be a major struggle to get the DJIA to 9000. Wall Street finished the year with a nice run in stocks and bonds because it suspects the chances of a higher funds rate have nearly vanished and it is time to begin discounting a cut. Greenspan is now a negative force, though, as he has demonstrated a taste for an optimum gold price in what we consider a deflationary range, and he has a Federal Open Market Committee that leans in his direction for reasons other than gold. The constant threat of a better economy and lower unemployment will keep a leash on the stock market, which is what we think Greenspan prefers.
He is, though, not almighty. The most positive factor weighing in our estimate for 1998 is in the political realm. Both political parties are now in a tax-cutting frame of mind, given the early estimates that projected money will be available on the scorecard of the Congressional Budget Office. The GOP leadership, fractured nine different ways on personalities, is at least eager to bring another tax cut into the November elections, and is focused on ridding the system of the marriage penalty. The White House and the Democratic congressional leaders are cooking up more targeted tax cuts, expecting to cut a deal with the GOP Congress. The growth effects of these maneuvers would be small and would not translate into serious numbers on Wall Street, except for shares of H&R Block. If we could realistically get anything out of Washington in 1998 on tax cuts that would translate into higher numbers, at least in NASDAQ, it would be in slashing the 18-month holding period on preferential rates on capgains to no more than six; even twelve months would be of help.
Of course, the problem with any positive tax cut is that it will increase the demand for dollar liquidity even more, and Greenspan would dig in his heels as he did all during 1997 as the gold price declined further. We just can’t be sure. This leads us to assume no net effect on the value of equities this year because of what might happen on the tax front. The pluses and minuses wash out. The more important news will be the outcome of the November elections. What we will be assessing all year is the counterpoint between the two parties in developing the themes that will be fought out. In this shifting political environment that history will look back upon as a party realignment, it is more important to anticipate the mandate that will come out of Election Day 1998 than the number of seats each party holds -- numbers that should not change much anyway. President Clinton will have two years left to work with a 106th Congress that we see no reason should not remain Republican. There will be serious debate about fundamental tax reform this year, although nobody expects much more than hearings. If all goes well, we could see a DJIA above 9000 by the end of the year, but we don’t expect all to go well. The divisions in both parties over how to deal with prosperity and a budget surplus are serious, which means we may have to wait for a presidential mandate in 2000.
The most positive year-end development was the decision by Jack Kemp to stick his neck out in identifying the Fed as the source of the Asian financial turbulence, urging the replacement of Michel Camdessus as head of the IMF, and breaking ranks with the Establishment on how to deal with Iraq and South Korea. A more forceful Kemp would help pick up the momentum behind positive, growth policies. It was also encouraging to see House Minority Leader Richard Gephardt take a more forceful role in goading the President toward a more ambitious agenda for the Democratic Party. I continue to believe Kemp and Gephardt will be the rivals for the Oval Office in 2000. Vice President Al Gore is what Kemp terms a “neo-Malthusian liberal,” whose trademark is global pessimism. Gephardt is an old-fashioned, pre-Vietnam labor liberal. The jockeying for 2000 will be of great interest this year, but will not do much to change the numbers on Wall Street.
Adding all this up, my best guess is that we will see the DJIA rise above 9000 this year, with some give from the Fed, but end somewhat lower, say 8800. Yardeni sees the Consumer Price Index up only 1.4% at the end of the year, the lowest number of the 50 economists offering forecasts today. Before I saw the number, I told a few clients by telephone that I would not be surprised to see the CPI below 1% for the year, given the sharp pull of gold below $300. I’d rather see enough monetary ease to get gold at least back over $320, in which case 1.4% on the CPI would look pretty good. Yardeni sees the long bond at 5% at year’s end, but that low of a number is what I would have picked if I still had the confidence in Greenspan that I had a year ago. A good part of the long bond involves the uncertainty of what the Fed board of governors will or won’t do. Unless I see a guiding principle that makes more sense than “wage inflation,” “irrational exuberance” or the Phillips Curve, I would not see the long bond ending the year below 5.5%, but we clearly are moving in that direction.
As for the dollar/yen rate, Yardeni sees it going to 140 and I don’t think that will be enough to relieve the incredible monetary deflation they have put themselves through. If the dollar/gold price climbs back to $325 or above, it would be. But if gold stays below $300, the dollar/yen rate should go to 145 or so. There’s no reason to be anything but upbeat this year, but not exuberant.