Executive Summary: The dazzling 15% surge of the Dow in the first six weeks of 1987 had parallels in the 1920s in the U.S. and France, in the 1960s in the U.S., and in Japan during the last dozen years. The market continues to digest the impact of the tax reform and has not yet fully capitalized its value. A Dow of 3000 by 1989 is more likely than not, a doubling from current levels possible in the early 1990s. The greatest threat to the bull market, as in the 1920s, is protectionism. But a review of The New York Times of 1927-28 is reassuring. A "protectionist threat" was not then generally perceived. And both political parties had protectionist postures in the 1928 elections, to which out 1988 elections will be parallel. The worst-case scenario for this year would require continued fumbling by Treasury's Baker on the exchange-rate controversy, keeping growth rates submerged in deflationary Japan, stoking the U.S. trade deficit and blind anger on Capitol Hill, leading to a veto override. But recent signs suggest Treasury is inching in the right direction and relief should come by the Venice economic summit in June.
Reflections on the Bull Market
The 15 percent dash of the Dow Jones Industrial Average in the first six weeks of 1987 seemed especially dazzling against the news accounts of the records being broken. But if we look at the splurges from early 1927 to September 1929 in percentages, there were many equally breathtaking daily and weekly advances.
The Dow doubled in the 18 months from the opening of 1928 to its peak in mid-September 1929. The New York Times industrial index began the decade at 90 and opened 1927 at 180, then hit 469 on September 19, 1929 — a 420 percent gain over ten years, 160 percent in the last 32 months alone. There were bursts on the Paris bourse from 1927 to 1929 that were even dizzier, following the Poincare tax and monetary reforms.
In the current era, we've watched the Tokyo market in a climb almost as dramatic as Wall Street of the 1920s. The Nikkei index has advanced from 4,000 in 1974 to just under 20,000 today — 400 percent over about a dozen years. The advance is almost as large in real terms, using gold as the yardstick: It took about 50,000 yen to buy an ounce of gold in 1974 (at 292 yen x $160 gold) and, while there have been sharp swings in both directions, the gold price is still 60,000 yen today (at 150 yen x $400 gold). (Is it any wonder Japan has enjoyed such a low cost of capital throughout the period?)
Against these examples, the market rise on Wall Street since 1974 has been fairly modest, only about 200 percent, but less than half of that when measured in gold dollars. The Kennedy-Johnson bull market dash from 535 in August to 1000 in February 1966 was more on the order of the sprint we've been seeing so far. Given the parallel with the 1920s, we would not be terribly surprised to see the Dow double again by the early 1990s and would be disappointed if it didn't see 3000 by the end of the decade. Our assumption is that the market has not yet capitalized the entire value of the 1986 tax reform and has only capitalized a portion of the monetary reforms that are still underway. This isn't to reject the concept of efficient markets, which posits an almost instantaneous discounting process as new information reaches the market. But while the markets know what the new tax law says and have some information on what a new monetary order may look like, they don't exactly know how human beings will rearrange their economic behavior within this framework, or how fast the new efficiencies will be achieved.
Roland Caldwell of Caldwell & Co., Venice, Fla., comes close to this in his January 23 newsletter titled "Hang in There — The Best is Yet to Come." Caldwell, a longtime supply-side portfolio manager, writes:
As we attempt to think our way through what is becoming a myriad of implications from the new changed tax rates, both for corporations and for individuals, so many potential courses of action are suggested that it is difficult to know which one is best for any given set of circumstances. This suggests that it will be awhile yet before it is clear, either to investors or to business leaders, as to what they should do to best serve their respective self interests under the new laws. Just as some might make a convincing case that high dividend payouts, for example, should now be favored, an equally convincing case might be put forth that no dividends should be paid at all but instead all profits should be reinvested for growth. The thing that is becoming more clear as each day passes is that the net effect of the lower tax rates seems likely to be much more favorable to everyone than was initially or widely understood.
Russ Redenbaugh of Cooke & Bieler, Philadelphia, PA, another longtime supply-side portfolio strategist, suggests a neurobiological metaphor. "It's like reading the best book on how to improve your tennis game. You can't just put the book down and go out and suddenly find you've dramatically improved your tennis game. But little by little, the information gleaned from the book can be absorbed by trial and error into your neurobiological system. That's what we're watching in the markets."
These observations suggest that if tax and monetary policies were frozen in place as of the moment, we would continue to see steady improvement in the financial markets and real economic activity. But no such freeze is likely, which means economic policies at home and abroad will continue to change, for better or worse.
What will we worry about? Gov. Wayne D. Angell of the Federal Reserve Board put it cogently in his January 16 address to the University Club of Chicago: "Some of the unusual conditions of the last year are behind us, but we continue to face important uncertainties — about movements in exchange rates and oil prices, about prospects for foreign growth, and about how successfully we will resist the pressures for protectionist trade actions."
I spent an recent afternoon reading The New York Times of 1927-28 on microfilm, browsing to get a fresh feel for the period in hopes of understanding the current bull market a little better. Several things came through.
1). Then, as now, there was little appreciation of the impact of the Coolidge/Mellon tax cuts on the market. On November 1, 1927, for example, the Times' lead story told "Mellon Advises Limiting Tax Cut to $225,000,000," the Treasury Secretary submitting his recommendations for a cut in the corporate tax rate to 12 percent from 15 1/2 percent, repealing the estate tax altogether, and making other helpful adjustments. The New York Times Index rose 2.17 on the day, to 226.53, yet the market commentary puzzled on why there should have been so much action, fixing on "speculation" and "liquidity" in the markets, sniffing at the Mellon statement because "Many bankers and others in the financial district had counted on a larger reduction than the maximum of $225,000,000 which the Secretary fixed." Two weeks later the index was at 239.89, up 15 points from the Mellon announcement, a 7 percent rise. In a story headlined "Stock Exchange Movement Again Confused," the Times ruminated on November 17 on this "wholly meaningless market, except as it reflected the maneuvering and colliding of professional speculators." Ten months later, with the index at 286.33, the Times huffs on September 21: "Even from Wall Street's viewpoint, developments in the credit situation were unpleasant yesterday, but the stock market can scarcely be said to have paid attention to them."
2). Protectionist forces are reported in almost every edition in one way or another, but almost never as a "threat." In 1927, the farm sector is constantly pleading for a reduction in tariffs on manufactured goods, hoping this would bring increased foreign buying of U.S. farm goods. Coolidge rejects this argument, according to the November 16 Times, holding "that present prosperity, to a great extent, is due to the tariff, that any real reduction would lead to industrial depression and that lack of prosperity among the factory workers would lessen the farmers' markets." A tiny story on p. 38 the following day is marvelous in its prescience:
During the next few years America will be confronted with one of her most stupendous problems, Lt. Col. Sir James William Leigh-Wood told members of the British Empire Chamber of Commerce yesterday at their monthly luncheon at the Whitehall Club.
"When England was the banker to the world at large, she built railroads in South America," Sir James said. "She brought back wheat; she brought back raw materials; she manufactured them and exported them all over the world because of her geographical position. That I do not think is possible here. Therefore, there will come a time when America is going to lend to the world. How is she going to be paid? She doesn't want more gold; that is superfluous. She won't take goods, because she puts a tariff wall to keep them out, and she has not got the service because she hasn't the merchant marine.
"The Englishman lives on the sea. You have tried to make maritime marine and you have failed. What are you going to do? There will come a time when the country to whom you have lent money must remit it. How are they going to do it? You don't want gold; you won't take goods. What is to be done? [Ans: Smoot-Hawley]
3). The Democrats did not stand up for free trade. Why? Probably because the Coolidge/Mellon bullmarket was so popular the opposition party was intimidated. In the 1928 elections, with Hoover versus Al Smith, there was no free trade option. The GOP had been needling the Democrats throughout the fall campaign of 1928 of trying to appear protectionist when in fact they were not. The September 21 Times, for example, reports that Dr. Hubert Work, the GOP national chairman, had accused Al Smith of trying to "hand the country a sugar-coated pill" in his acceptance speech. "The erroneous impression has gone forth and is spreading," Dr. Work wrote, "that there is no material difference between the Democratic and Republican stance on the tariff this year, consequently many are prone to say the tariff is not an issue. That impression is wholly erroneous; it should be corrected. The tariff is and should be a vital issue in this campaign."
The Democrats could have chosen to go with their traditional anti-tariff position and accept the GOP challenge, but they wimped out. The October 7, 1928 Times quotes John J. Raskob, chairman of the Democratic National Committee:
The Governor knows that this country is committed to a high standard of living, which requires high wage rates. High wage rates make production costlier in the United States than it is abroad. Therefore we must have tariff protection. Alfred E. Smith comprehends this as clearly as I comprehend it, or as any other businessman comprehends it. He knows that high wages both in industry and agriculture, and a fair return on capital employed in both, spell increased purchasing power. The Governor believes in protection, but he wants the protection to be general — to be spread equally over industry including agriculture — not piled up here and thinned out there, unjust and inequitable. He believes that all legitimate business should be fostered and protected under the tariff, but he does not believe that special interests should be coddled under the tariff.
4). Because of the absence of a national debate on the tariff issue in the 1928 campaign, it's easier to see how the legislation could be enacted during the market crash and no voice is heard making the connection. Two months after the crash, with the Times still calling it a "slump," the newspaper reported on a speech by Dr. John H. Gray, former president of the American Economic Association, in which he names Coolidge and Mellon as the "individuals most responsible for 'continuing and extending the mania' of speculation which preceded the Wall Street slump of last Fall." While praising Hoover's post-crash business conference as being psychologically useful, Dr. Gray criticized Mellon and Coolidge "for always insisting that all was well and talking of prosperity, a new era and increased efficiency of production as justification of high stock prices." According to the Times: "As a practical way of altering American attitude toward wealth, Dr. Gray suggested the lessening of the 'concentrated absentee ownership and control of money and credit' and the 'more equitable distribution of the proceeds of industry.' That alone, he said, could stop speculation or 'curb the Stock Exchange or lessen armaments or prevent war.' The most hopeful line of attack in this direction, Dr Gray said, was income and inheritance taxes and 'a general limitation on the right of bequest.'"
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The afternoon of microfilm browsing was reassuring. The same protectionist forces have assembled for an assault on the current bull market, but there has been some progress made in the last sixty years. There are voices being heard connecting the Reagan tax reforms with the bull market. (See Alvin Rabushka's February 13 op-ed article in The Wall Street Journal.) The phrase "protectionist threat" has become imbedded in the national vocabulary, and at least many Wall Streeters have been persuaded that Smoot-Hawley triggered the Crash of 1929.
Protectionism, of course, remains the greatest threat to the bull market; all of the other threats can be looked upon as a subset of the protectionist threat — turbulence in the exchange markets, slow growth abroad, the Wall Street scandals that encourage the politics of envy (and regulation), and the battering ram of the twin-deficit theory, which invites recession as a cure for the trade imbalance.
Unlike 1928, it is hardly likely that these forces will get a free pass in the coming presidential elections of 1988, and they really can't get very far as long as President Reagan is in the Oval Office. The worst that could happen in the 100th Congress is for a trade bill to take shape that is almost acceptable to the White House, which the President vetoes with a limp message, both houses then narrowly overriding the veto. To get this much, the legislation would have to be fairly weak or the Administration strategists would have to be terribly inept. The one exception to this scenario could come about if there is not even marginal improvement on the trade account and the atmosphere on Capitol Hill becomes so poisonous that a majority of Republicans are ready to join in overriding a Reagan veto. Having control of the Senate makes it a bit trickier for the Democrats. It would be less risky, politically, to override a Reagan veto with a GOP Senate and a Democratic House. If the market did tailspin and the world economy slump amidst trade wars, the White House could not then pin the tail on the donkey. This worst case scenario, then, seems highly improbable at the moment. The expectation is that growth abroad will pick up soon and the trade deficit will be on a declining slope. Treasury Secretary Baker is supposed to see to that.
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While January was a sensational month for Wall Street, it was not a good one for Secretary Baker. In his continuing maneuvers against the forces of protectionism, he finally had his past catch up with him. The cumulative little errors he piled up in 1985 and 1986 as he successfully zigged and zagged on tax, trade and exchange-rate issues, finally entangled him hand and foot. The black art of obfuscation on currency matters turned into "A Surplus of Economic White Lies," which was the headline of a New York Times editorial that cited Baker as "the chief public word wobbler" on the smouldering exchange-rate controversy.
Remember, after a dozen years of U.S. benign neglect of the dollar, it was Baker who emerged from the September 1985 Plaza Hotel meeting of finance ministers as the champion of exchange-rate stabilization. Yet here he was, spending January 1987 denying that he was trying to drive the dollar down, insisting that he didn't know where the dollar should be, and having it said by the White House that he didn't disagree with Paul Volcker that it had fallen quite enough — except, Baker complains, against the currencies of Taiwan and South Korea. (What about Hong Kong, Singapore and South Dakota?) As an attest to his credibility after all his denials about secretly sinking the dollar, the Times of February 1 announced as fact that "Baker and his team" had "engineered" the January dollar devaluation.
At the center of Baker's problem, like a bone in his throat, is the continued fiction that a weaker dollar will reduce the U.S. trade deficit by improving U.S. competitiveness. He and his deputy, Richard Darman, have strained to believe those of us who have repeatedly warned that the U.S. trade deficit would increase as Germany and Japan deflated their currencies — not as Baker says because they might not be able to export as much, but because they would not import as much.
Baker pinned so many of his hopes on this weak dollar idea in his dealings with congressional protectionists that he has little credibility when he tries to backpedal. His other problem is that he has believed the correct arguments that Japan and Germany have to increase their growth rates for the U.S. trade deficit to decline. So he must actively and publicly agitate for "fiscal expansions" in these two countries (supply-side tax cuts in Germany being considered equivalent to demand-side public works projects in Japan). But the net effect of easy fiscal policy and deflationary monetary policy is zip. This is what Donald Regan found in 1981 and 1982 when he listened to supply-siders on taxes and monetarists on money and the Reagan tax cuts were offset by the Volcker deflation. Baker has supply-siders whispering in one ear, Keynesians in the other.
Having hammered the Japanese into deflating the yen, Baker now finds the bitter fruit of this effort is resistance by Tokyo to pleas that it 1) expand the economy by fiscal means, and 2) lower import barrier to help on the trade issue. That is, the weak economy has so impacted its budget that the Japanese government feels it has little room for tax-cut/spending. And Japanese industry, weakened by the yen deflation, is fighting U.S. pressures to restrain exports (semiconductor chips) and reduce import restraints. If the situation were reversed, the United States would be behaving the same way.
If Baker could put together a simple agreement with the G-5 or G-7 (adding Canada and Italy) finance ministers, to put a floor under further dollar declines, we'd have the beginning of a solution, a way out of the tangle Baker has gotten himself into. With the dollar steady at gold at $400, the yen would have to fall to the 175 range to relieve the deflationary pressures that are continuing to spread through the Japanese economy — forcing their companies to "dump" exports on third countries.
The problem, as Rep. Jack Kemp put it in a February 12 letter to the President, expressing "alarm" at the apparent breakdown in the secret G-5 talks, is that Baker has been trying to do too much at once. Instead of trying to mastermind and then orchestrate an intricate, comprehensive monetary and fiscal coordination of the major industrial nations, Treasury should be concentrating on undoing the grave damage it has done by its orchestration of currencies in the last six months.
We're encouraged by signs that Treasury is inching in that direction — especially its new willingness to discuss the negatives of exchange-rate changes abroad. There's still plenty of time to work things out, and there should be achievements by the economic summit meeting in Venice this June. The finance ministers, central bankers and heads of state involved all sense that this global bull market will come to an abrupt end — if they can't find a way to head off the advancing protectionists. We're almost certain they will.
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