Beginnings of a Bull Market Jude Wanniski May 30, 2003

The New York Times last Saturday reported in its business section that Wall Street yawned when it saw the President`s tax cuts approved by Congress. I contacted the reporter, Alex Berenson, and advised him that the market began discounting the possibility of this excellent tax package back in March. The financial press had attributed the rally that began in mid-March to the war in Iraq, with the idea that a "certain" war was more positive than an "uncertain war." At the time, the market movements made no sense in a supply-model. The fact that gold was falling as the risks associated with war increased did not compute. When Bush pulled the trigger on March 17, financial commentators grasped at the idea that the "uncertainty" on whether there would be a war or not was lifted, and this in itself buoyed the market. This could only make sense in a Keynesian model and then only barely. On that same day, though, the House Budget Committee reported the Budget Resolution providing for $726 billion in tax cuts. On March 21, at 2:54 in the morning, the House passed the resolution by a 215-212 vote, a huge hurdle.

It suddenly became clear to me that the tax bill we had been ignoring -- on the grounds that Congress would not pass the supply-side elements of the bill, only the social tax cuts -- had real possibilities. Before noon that day, we sent a client brief: "New Hope on Dividend Tax Cuts." The market`s big move that day foreshadowed the path that Congress followed in producing the bill that emerged. In a letter to the Times in reference to the Berenson article -- which the Democrats cited on all the weekend talk shows -- I noted that the much lower taxation on capital formation had already added $600 billion to the value of the nation`s capital stock. This took place in a rally of several weeks, which meant it has already PAID for itself, in that its total estimated cost to the U.S. Treasury was only $320 billion over a decade. Berenson said he thought I was wrong. He had interviewed three of his best sources on Wall Street and they all said the rally was due to the war news. But they had been reading that explanation in the financial press and had no other to fall back on.

What we have is the beginnings of a bull market, the earliest stages of what would be a virtuous cycle that feeds on itself as opposed to the kind of vicious cycle that is at the heart of all bear markets. The market in its first stage has been able to see that the odds have changed for the better on the prospects for the economy`s future. It now has to see the actors in the real economy actually respond to the added incentives to capital formation. To the degree that happens, the market will advance further. In a rough sense, the market is like a tote board at the racetrack, which reckons the odds before the gates open. The outcome is then the result of the real event of the race. When the Kennedy tax cuts passed in early 1964, the market followed that path, climbing over the next two years. The "animal spirits" in the economic system steadily reacted to the fresh capital that was forming in response to the lower marginal tax rates on incomes and on capital gains. The bull market ran out of steam when it had to discount the likelihood of the Vietnam War tax, a surtax on income taxes.

My sense now is that the major indices will continue to advance, perhaps climbing as high as 10,000 on the DJIA during the next year, everything else being equal. The negative forces that could hold it back will be a decline in the dollar/gold price, which would be deflationary, and a breakdown of the road map in the Middle East negotiations, which would be inflationary. When we saw the dollar/gold price quickly run up yesterday afternoon by $5 in a few minutes, soon accompanied by a 100-point swoon in the Dow Jones Industrials, we could only surmise it was related to the talks between Israeli Prime Minister Ariel Sharon and Palestinian Prime Minister Mahmoud Abbas. A few minutes before noon, Bloomberg blurted a news story that Sharon announced Israel would never give up Jerusalem. Soon after noon, White House press secretary Ari Fleischer seemed to be siding with Sharon over Abbas on a report that Abbas was getting a promise of a ceasefire from Hamas. My reading of the transcripts indicated Bloomberg`s reporters had overplayed both statements and the markets would come back when the accounts cleared up. Note the markets moved back up today and gold has fallen back to where it had been.

There are other positive forces at work. We think that the Bush Administration soon will be working on a commission to study fundamental tax reform, and there is little doubt that it will be dominated by supply-side ideas. The reason we know that is because Treasury Secretary John Snow was a member of the 1995 Kemp Tax Commission and an enthusiastic supporter of its conclusions for a simplified tax system with a "flatter" tax. It would not be a surprise if the President asked Kemp to join the effort, perhaps even co-chairing a commission with some prominent Democrat (Bill Bradley?). Congress is also now committed to studying a fundamental reform via the Joint Economic Committee, this the result of a sense of the Senate resolution that passed by a 70-to-30 margin. The business and financial press has paid little attention to these new balls about to come into play, focused instead on the rantings of the Democratic presidential hopefuls who are now promising to roll back the Bush tax cuts. On this track, President Bush would win a landslide re-election in 2004 and bring with him a veto-proof Republican Congress. So there are upside possibilities along with the downside threats. But for the moment, we are clearly in the early stages of a new bull market.

* * * * *