Wall Street's Elusive Inflection Point Jude Wanniski May 1, 2002

When the gold price was $265/oz. we forecast that the Dow Jones Industrial Average would need to fall to 8500 before the monetary deflation adjustment would be complete. When gold climbed to $300 because of increased risks to production and exchange, we adjusted the forecast to 9400. The recent six-day market sell-off that brought the DJIA below 10,000 for the first time in three years – excepting the temporary dip last year associated with 9-11 risks – brings us within striking distance of the 9400 target. And with our bullish gold call continuing to work, as the dismal news about fiscal deficits increases chances of tax increases at all levels of government, the DJIA target may be a little higher than 9400. It does seem wacky, I know, but the worse things get, the sooner the deflation will end and the DJIA will stop its decline. The bad news is that the deflation will be replaced with contraction. Certainly there is nothing on the horizon to suggest a sustained rebound of the S&P500 or DJIA.

On March 17, 1999, when the DJIA had finally crossed 10,000, I wrote a client letter, "DOW AT 10,000: THE EASY PART." I pointed out that in real terms as measured by gold, the index was only back to where it was in 1966, when it briefly touched 1000. It fell away as President Lyndon Johnson`s Vietnam war surtax gained ground, and adjusted for gold did not get back to the same level for 33 years. When the DJIA hit 10,000, Lawrence Kudlow wrote a WSJournal op-ed correctly attributing the bull market to Ronald Reagan`s tax policies and Alan Greenspan`s Fed management, but he made the mistake of predicting the DJIA would be at 50,000 by the year 2020. A number of others wrote books at the time, seeing a DJIA of 20,000 by 2020, with one exuberant supply-sider predicting 100,000. None mentioned the price of gold, so if there is a great inflation in the next 18 years, they can crow over their correct forecasts. But that`s the only way the averages can get up that far that fast. Even Robert Mundell decided to play that game at our client conference two years ago in Florida, predicting a DJIA of 20,000 by the year 2010. When I asked him what the gold price would be relative to the $300 at the time of the conference, he suggested $600 an ounce as a likely number! If all prices double in nominal dollars, of course nothing has changed.

On the track we are on, we would not see much action increasing the real value of financial assets. Yes, there are productivity gains to be had by replacing people with computer chips, but these are the kinds of gains that are limited by the competition from the workers the computers have replaced. I`d had this discussion with Greenspan a number of times – when we were still on speaking terms – but he always seemed perplexed when I pointed out that technological advance has not prevented several billion people on earth from living in poverty. The "New Economy" built around computer chips needs a hospitable economic and social climate if it is to flourish, and what we have seen thus far in this bear market are sun showers compared to the lightning storms ahead.

Our Christopher Ecclestone, who knew there could be no recovery under deflationary pressures, looks ahead with this assessment: "Some companies in their earnings outlook statements have pushed their pot of gold farther along the rainbow, but others have been more frank, talking of recovery in 2004 (in advertising volumes, in this case) or refraining from projections beyond Q2 of the current fiscal year (in the case of employment agencies). This is scarcely the type of stuff that analysts and investors want to hear when the P/E ratios are stratospheric in many sectors and highly dependent upon a rip-roaring recovery. In the coming month, investors have to come to grips with the reality of a recovery that is weaker than promised. The surest sign is Alan Greenspan’s decision to delay rate hikes. Moreover, as the view spreads globally that the U.S. recovery is not running to the timetable and with the dollar further weakening against gold, foreign investors may want to take their stakes off Wall Street’s table. This could compound the woes for the market stemming from a dull earnings season and deteriorating growth outlook."

The contraction that is gradually replacing the deflation is wrecking public finances at every level of government. Every time we look, the Bush administration is announcing deepening federal deficits, even as the President hails the robust GDP statistics that are the result of massive spending increases. There is no end in sight to this red ink. The National Conference of State Legislatures reports that the states got their 2002 budgets cobbled together in time to meet deadlines. Now they face 2003 budgets with no idea how they will confront the gaps opening up – which were supposed to be closed by the economic rebound. Even if there were no macro problems associated with the monetary deflation, the fiscal picture would be getting worse because of runaway Medicare costs that burden the states.

We think back to all the client questions we got about the bond market when gold was in lower ranges. Why were the yields so high if prices were falling? Our answer was that the risks to bonds were inherent in the absence of a gold price rule, with a central bank whipsawed with forces out of its control as it concentrated on managing GDP. The market never had any assurance that the gold price would remain low and that budget surpluses would continue as far as the eye could see. The long bond is still a buy at yields above 5% or so, because that level incorporates the risks we are now experiencing — as opposed to anticipating. Gold would have to soar to cause a bond collapse.

Michael Darda also notes that the monetary aggregates that had been climbing during the worst of the deflation pressures are now beginning to fall. When gold falls, in other words, returns to risk-free cash rise and the returns to capital fall: "Now, some commentators who NEVER worried about gold falling and who have been citing fast 'Ms' growth as a sign of 'easy' monetary policy for the last five years, have now decided to point out that gold is rising while failing to mention that the Ms are moving in reverse at the same time! It should be no surprise that a falloff in dollar demand at the margin has been accompanied by a backing off in the Ms. Even the monetary base, which still is up 10.1% YoY, has gone into reverse."

The biggest risks remain in the Middle East, where things can only get better or worse. There is no treading water there. Secretary of State Colin Powell does seem to have the upper hand over the War Party in the Bush administration, which not only does not want Peace with Palestine, but is also itching for war with Saddam Hussein. As long as the President George W. Bush and Powell make progress toward a Palestinian state along the lines of the Saudi proposal, chances of another 9-11 will further recede. And so will an invasion of Iraq. This scenario seems more likely than not and of course will be good for financial assets. Still, we still have a short trip south before we reach an inflection point.