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Jewish World Review June 14, 2001/ 24 Sivan 5761

Lawrence Kudlow

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Better Times -- STOCK markets are surging in anticipation of stronger economic growth and profits over the next twelve months. Equity markets have decided that better times are coming, even with Jim Jefford's defection to the Democratic side of the Senate. It now appears that a year-long bear market ended in March, and a new bull market began in early April.

For the historical record, this marks the tenth bear market and the eleventh bull since 1947. During that half-century period total returns from the S&P 500 index increased by 69,000%, or 13% per year. Inflation-adjusted economic growth and corporate profits averaged 3.5% annually over the five-decade span.

Over the past year spiking energy prices and an inverted Treasury yield curve from deflationary Fed policies were the prinicipal growth and wealth-stopping prosperity killers. Added to that, investor spirits were dampened by the Federal over-regulation of technology companies (Microsoft) and a hefty hike in individual tax burdens from income bracket creep. Also, a modest inflation rise pushed up the effective capital gains tax, another wealth-reducing factor that pulled down the after-tax value of stock market assets.

Fortunately, market forces are replenishing energy production at reduced prices. Free market prices work, a concept ignored by the media and certain California politicians, but one that is contributing to substantial drops in the cost of oil, natural gas, electricity and gasoline.

Higher prices over the past two years have led to a record oil rig count, massive new refinery investment and an estimated 100,000 megawatts in new electrical generating capacity expected to come on-line next year. As a result, the Mirant national power price index has collapsed in recent months, and its current demand-weighted average price for the continental U.S. is 83% below its 52-week high.

This is particularly important to high electricity-absorbing technology companies that need a reliable electricity flow at reasonable cost. More generally, the 1999-2000 energy spike crushed corporate profit margins. At the margin, energy cost increases exceeded consumer price gains.

In fact, the bear market economic downturn derived largely from a brutal pincer movement whereby businesses were caught between spiking energy prices and the Fed's deflation of liquidity and the economy. Consequently, as if declining sales revenues weren't bad enough (from falling GDP growth), profits were further damaged by spiraling energy costs.

The collapse of profits (down 18% over the past four quarters) reduced capital returns and forced a contraction of investment, production and employment. Technology, the sector most sensitive to energy costs and prospective capital returns, was hit hardest by the OPEC-Fed pincer effect that decimated profit margins. This helps explain why the Nasdaq index dropped far more (59%) than the broader S&P 500 (18%) over the bear market period between March 2000 and March 2001.

The free-market capitalist system cannot grow without profits. Profits from companies both large and small are the heart of our business system. Now, however, as energy and monetary obstacles to profitability and growth are receding, earnings will be restored. The stock market is sniffing this out.

The Fed has acted aggressively this year to normalize the Treasury yield curve through rapid fed funds rate reductions that have brought short rates below medium and longer rates. Now the curve is upward-sloping, a sure sign of future economic recovery. Using a Treasury yield curve model of the economy, the probability of recession in 2002 has dropped to only 14%, though it remains at 50% for this year's second half.

As the fed funds rate has declined, monetary base growth has accelerated to 6.7% at an annualized rate over the past six months, well up from only 1.7% for the six months to last October. The monetary base, consisting of bank reserves and currency, created by Fed purchases of government securities, is the basic liquidity measure controlled by the central bank.

Here's another Fed point. The central bank has reduced the funds rate more (250 bps) than it previously raised it (175 bps). That implies considerable stimulus.

As the Fed's interest-hike tax on money has been lowered, both investment and transactions demands for money are improving, though precautionary cash balance levels in money market funds are still quite high. Additional money demand recovery will unfold in the months ahead. And the Fed will accommodate rising bank reserve demands to push more high-powered cash into the financial system.

Essentially, Fed actions have removed monetary policy as an obstacle to recovery. The overnight funds rate could drop another quarter of a point, or two, but Fed policy easing is basically over.

The central bank has done its job according to key market price signals from gold, commodity indexes, the TIPS spread, the 10-year Treasury and the King dollar exchange rate. Deflationary pressures have given way to open-market signals of price stability.

A stable Fed policy for the next year would be optimal. The less fine-tuning, the better. Investor spirits and capital spending decisions will recover more quickly with a stable monetary policy. Any delaying effects should give way to more decisive and positive economic actions, especially if earnings recover through faster GDP growth (for better sales revenues) and a more balanced cost-price structure (for a profits revival).

A money market forecasting model of economic growth estimates a flat economy for the second and third quarters, then 2.3% real GDP in Q4 and 3% growth during 2002's first half. S&P operating earnings behave similarly, with an impressive 14% rise in next year's first half.

A commodity forecasting model of inflation suggests that broad price indexes could slow to 1.5% to 2%. Interest rates on Treasury securities across the maturity spectrum should be relatively stable, though corporate rates could fall and quality spreads will continue to narrow. Ten-year Treasuries should fluctuate between 5% and 5%.

Stock markets are already discounting this economic improvement, as the S&P has rebounded 15% from its April 4 low. Steady interest rates, declining inflation and improving profits will sustain the market advance over the next year. Capitalized corporate profits are estimated to rise 62% between Q1/2001 and Q2/2002. Theoretically, the S&P could rise another 25% to 1610 by the middle of next year.

The incentive benefits to work and investment from reduced marginal tax-rates - with the top personal rate dropping to 35% -- will occur gradually over the next five years. However slowly these new incentives kick in, at least the direction of tax-rates is down, not up.

Also, the same static revenue estimates that hogtied the tax bill will also block major new spending initiatives from Congress during the next couple of years. Sen. Daschle and Co., eat your heart out. And forget about electricity price caps. There's a 55 vote pro-market Senate majority to assist President Bush in his efforts to throw back the evil forces of darkness.

However remote, there is still a possibility that capital gains tax relief is possible, perhaps coupled to a minimum wage bill. Not only a 15% rate, but also elimination of the one-year holding period.

Another legislative proposal envisions a 50% exclusion from the new 35% top rate, which would lower the basic capgains tax-rate to 17.5% from 20%, producing a modest 3% incentive improvement on top of the 12% incentive gain from lower individuals tax-rates. Also, reduced inflation lowers the effective tax-rate on real capital gains, providing even greater rewards for risk-taking and capitalizing innovative new ideas and management practices.

The new information economy was temporarily jolted off its prosperity path, but the transforming effects of technological advance and free market policies will continue to dominate for many years to come. The digital economy is alive and well.

Schumpeterian gales of creative destruction will lead the technology revolution to energy, space, defense and other old-economy users. Upgrades in computers, software and semiconductors will continue. Internet uses and applications will spread. Bio-tech is on a roll. Technology-driven back-up power systems will proliferate. Productivity growth has not yet peaked.

Along with sound money, lower taxes, additional deregulation and free trade, information age prosperity has a long way to run. Free enterprise is in the driver's seat, and better times are coming. Recovery is in the air. Keep the faith. Faith is the spirit.

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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