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Jewish World Review August 14, 2001/ 25 Menachem-Av 5761

Lawrence Kudlow

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Profits are economically correct -- IS there a light at the end of the stock market tunnel? If not a light, maybe a glimmer?

Well, yes, actually. Amidst all the deflationary evidence in July's producer price report there's one piece of very good news. Namely, producer profit margins registered positive gains for the second straight month. This upturn in profit margins appears to have ended a long drought of negative margins that stretches all the way back to July 1999, twenty months ago.

How to define producer profit margins? That's easy. It's the difference between crude material input costs necessary to make products and final goods output prices for selling those products. This information is contained in the producer price index reported monthly by the Labor Department.

For example, in the latest PPI report the twelve-month change in crude material prices deflated at a 5.4% rate. The finished goods component inflated at a 1.6% pace. The difference between the two is 7%. That is, plus 7%. A positive and profitable differential.

Now here comes the hard part. Despite our politically correct world, classical economics teach that businesses must be profitable in order to expand their operations, including investment in equipment, in research and development, in worker employment, and in worker training for better productivity. So profits are crucial, not merely because stock market investors yearn to see new profits, but in order to sustain business itself.

In other words, profits are good. Businesses are good. It is business that create jobs, and just in case any visionaries are reading this, it is capital that is necessary to finance business. Jobs need business and business needs capital.

Putting it all together, capital, business, profits and jobs are all good things. You might say they are all of the same piece, and that piece is prosperity. If not politically correct, it is economically correct. And, that means government policies to nurture capital and business are actually job-creating and prosperity-creating policies. Believe it or not, Mr. Al Gore, Sen. Tom Daschle, members of Congress, and the media too numerous to mention, etc., etc.

But I digress from the main point, which is that the appearance of a profitable spread between business costs and prices is indeed a very hopeful profits upturn omen for stock market investors, for economic recovery and for the increasingly unemployed American workforce.

Washington economist John Mueller has designed a model of stock market price-earnings ratios and producer profit margins. His research finds that positive business profit margins lead almost immediately to improving price/earnings ratios and higher share prices. John notes that the S&P 500 price/earnings multiple has already turned up, but this was largely a result of falling earnings, not rising shares prices. Now, however, with positive price margins anticipating rising corporate earnings, a major 20% stock market rally looks to be in the cards.

Another positive, if overlooked, stock market number came out this week. Institutional money market fund cash fell by $12 billion. It's the first drop in nearly two years. And it could be suggesting that mutual funds, hedge funds, corporations and wealthy investors are tired of acting like little old ladies in tennis shoes. Maybe they are ready to put their capital at risk in the stock market and the economy, where it will propel recovery.

Yet another positive number this week is from the Federal Reserve Bank of St. Louis. The basic measure of central bank liquidity, which is called the monetary base, and is defined as the sum of bank reserves and currency in circulation, continues to rise significantly. Over the past three months monetary base growth has moved from a negative 1% to a positive 11%.

As we all know, following the Fed's harsh deflationary policy last year, the plunging stock market and the flattened economy have been starved for liquidity. Now that the central bank has come to its senses, it is beginning to rebuild liquidity to finance economic recovery. As a crosscheck on whether the new liquidity supplied by the Fed is meeting the needs of a recovering economy, early signs of commodity price index stability have surfaced in recent days.

In ten days world financial markets will turn their eyes on the Fed's FOMC policymaking arm, which meets August 21. Undoubtedly Greenspan & Co. will lower their key interest rates again, thereby injecting more liquidity into the credit-starved economy. This too is a good omen for the stock market. (They should move to a 3% fed funds rate ASAP, then stop.)

According to the growing legion of bear market pessimists, things always look darkest before they turn completely black. But now both investors and workers may be seeing signs of that proverbial light at the end of the tunnel.

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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©2001, Lawrence Kudlow