Wall Street: Themes and Variations Jude Wanniski December 17, 1996

The unusual movements of the financial markets reflect several major forces that are pushing in different directions. The value of all assets is the net of the positive and negative forces bearing on them at any moment in time. The time of the year is one such force, because of the tax consequences of one calendar year against another. The confluence of political events and economic philosophies is another prime force at a given moment. In a world in which the unit of account, the dollar, can change quickly, the thoughts and actions of people associated with the central bank are of enormous importance, especially those of its chairman. We should also bear in mind that nothing in the financial market is real, in the sense that all prices, of debt or equity, are based on expectations of what economic reality will be in the future. Markets don’t surge or crash because irrational “bubbles” are forming or bursting. They do so as the individuals who comprise the market make their bets on the future, long or short, change their expectations and assign different weights to the likely reality that some day will arrive.

We see the pounding the high-tech stocks like Microsoft, Intel and IBM are taking, and wonder why, especially when they should benefit greatly if the new harmony in Washington finally results in a capital gains tax cut early in the 105th Congress. But it is precisely because there have been heightened expectations of such a reality that so much optimism has been built into the values of Microsoft, Intel and IBM. What if this reality is again thwarted, as so often occurred in the past decade? Better to lock in some of the optimism today, if it only costs a small amount. This is done by shorting against the box, the practice of borrowing 100 shares of IBM and selling them, to lock in the 1996 profits of the 100 shares of IBM you have owned all year. Then, if we get into the new year and see that the prospects for the tax cut have not changed, and know the effective date when the tax rate will be lowered, we will have to buy 100 shares of IBM to cover the short. The cost of bottling current optimism and profit is trivial. It is only the interest rate on the borrowed amount for the several weeks it will take for the future to be clearer. In other words, what appears to be an irrational pounding of the high-tech stocks today is a function of the calendar, and it will be offset by an offsetting surge after the first of the year as long as optimism about a capgains reduction remains where it is today.

Another major force we have pointed out is the new trading range for gold, at a pivot of $368/oz. instead of the $383 we had observed for the previous three years. There are positive and negative things that accompany a decline in gold’s trading range. The most obvious is that people who are long gold become sad and those who are short gold become happy. Up to a point, bondholders become happier because the value of fixed-income securities rises in real terms, as the dollar accounting unit -- which is a fictitious concept -- rises relative to gold, which is real. What about the impact of a lower trading range for gold on the overall stock market? Lower interest rates are good for enterprise. There’s a plus. Less inflation is bad for corporations with heavy debt, as they have to pay that debt down with more valuable dollars. That’s a minus. Less inflation is good for capital gains, which is not indexed, and is therefore penalized if the gold price rises. That’s a plus. The price of a financial asset, as opposed to its value, must fall when the gold price falls. This is the biggest downer we have to expect if gold’s trading range is cemented at the lower level, which is 4% below the old level.

Think of it this way. If the price of an apple goes to $1 from 10 cents, because of a general inflation, not a failure of the apple crop, the price of shares of an apple company will also rise tenfold. This is true, of course, only if everything else is equal. In a system of progressive taxation, a general inflation causes tax rates to rise, which means the price of the apple company’s shares will rise by something less than tenfold. On the other hand, if there is a deflation of the apple price to 90 cents from $1, because of a general deflation, not a boom in the apple crop, the shares of the apple company will have to fall by 10%, everything else being equal. It is this negative force which is bearing down on the equity markets. It is not entirely a negative force, of course, because 100 shares of General Motors may be down by 5% because of this force, but in terms of the purchasing power of the 100 shares relative to gold, the value of GM stock is the same. There is a “bubble” in dollars being squeezed out, but not in terms of gold.

We must bear this in mind for the future if we assume that Alan Greenspan would eventually like to get gold back to a $350 pivot, which is where it was when he became Fed chairman in 1987. That means another 5% monetary deflation may be headed our way in 1997. This will be good both for the price and value of bonds and bad for the price of stocks. In order to offset this minus, Greenspan should do whatever he can to make sure the capital gains tax is cut. This positive force will more than offset the deflationary minus of gold inching down to $350. In other words, the price of pulp and paper will be pulled down by a lower gold price, as will the value of the financial assets of pulp and paper companies. The lower capital gains tax will cause an increase in real economic activity, which will mean an increase in the demand for pulp and paper that gets the prices of those goods out of their current low levels into a more traditional relationship with the prices of other real goods.

This leads to the other major consideration we contemplate in these Wall Street themes and variations -- the economic philosophy of the major policymakers. Will the Federal Reserve allow the economy to expand more rapidly as a result of a cut in the capital gains tax? Or, out of concern for rising wage rates, will it insist on cooling the economy off with higher interest rates? This is the sinister force that took a bite out of stocks and bonds early today, when the report on increased housing starts was released. Because there is a real risk that the Fed will behave irrationally, which is obvious if it is fighting an incipient inflation when gold prices are falling, the market has to assume those risks. When Greenspan speaks about an “irrational exuberance” in the markets, he displays a weakness in his own understanding of markets. This also adds to the burden of risks that investors must shoulder. If, in January, when he must testify before the House and Senate Banking committees, Greenspan reveals that he has thought through that weakness in his understanding of markets, and has expunged it, the markets will rise in applause. If he defends his argument, it will be a signal that he wants to preserve an excuse, if he needs to pull one out of his pocket, to keep the economy at a weakened level to prevent a rise in the level of real wages.

In the overall netting out of these forces, plus and minus, we remain much more hopeful than, say, Barton Biggs of Morgan Stanley, who has decided not to fight the tape and yesterday announced that he is pulling his model portfolio down to 56% stocks from 74%, increasing his cash position to 15%. He did this with only 10 trading days left in the calendar year, and if we are right, he will be sorry he did when the new calendar year arrives with its positive realities for equities. As long as Senate Majority Leader Trent Lott keeps the GOP unified in Congress and President Clinton keeps the congressional Democrats in line, there should be a positive tide that pulls the markets up well into the new year.