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Who's Afraid of the Big Bad Bear? read
By Donald Luskin
April 22, 2005
DIRE HEADLINES. PANIC SELLING. Hundred-point swings in the Dow. The smell of fear has been in the air for weeks. What's the stock market so afraid of?
Whatever's been spooking investors, it must be big. Even after Thursday's rally, stocks are still very cheap. Before Thursday, if the S&P 500 had fallen just 5% further, it would've been as undervalued as it was at the panic bottom in October 2002, the climax of a thousand-day bear market that was the worst since the Great Depression.
The bad news is that I can think of several risks big enough to cause those kinds of worries. The good news is that these risks are just risks, and none of them is likely to become reality.
If I'm right, then equities are a bargain right now. As soon as the market realizes there's not as much to worry about as feared, stocks could rally by as much as 40% just to get back to normal valuation levels.
But on the other hand, what if I'm wrong? What if these risks are realized? In that case stocks aren't cheap, and you can forget about that 40%. But since the market has already discounted so much potential bad news, stocks probably don't have that far to fall.
High on the list of worries lately has been the idea that economic growth is slowing. I don't see it. Sure, IBM (IBM1) had a bad couple of weeks in March, but Intel (INTC2) and Texas Instruments (TXN3) don't seem to have had any problems. The Empire State manufacturing index came in weak a couple of weeks ago, but then on Thursday the Philadelphia Fed's index was just as big a surprise on the upside.
Readers of this column know that inflation has been one of my worries for over a year, and recently it has burst into the headlines. So now everyone's worried about it — which is precisely why I'm not anymore. Now that everyone's focused on it, especially the Federal Reserve, the inflation problem is on the way to being solved.
How about tax policy? There's so much turmoil in Washington right now — everything from a bitter debate over Social Security modernization to the risk of using a "nuclear option" in the Senate to get federal judges approved — that the extension of the pro-growth tax cuts on dividends and capital gains isn't getting the fast-track attention it deserves. President Bush campaigned on making them permanent, and now it looks like they'll just be extended by two years. That's a disappointment, but not a calamity.
There's another tax risk, too. President Bush has said "everything's on the table" in the Social Security debate in order to gain support from Democrats — and that means he's willing to talk about eliminating the cap on wages subject to payroll taxes. That would have the effect of rolling back the 2003 tax cuts for over 10 million workers — a catastrophe. But it's a low-probability risk, because the president is fundamentally opposed to it, and the Republican leadership in the House is even more firmly opposed. If that's the price of reform, then there'll be no reform.
In my view the biggest risk is the possibility that the government will do something really dangerous and stupid with respect to China.
Two weeks ago two senators — New York's Charles Schumer, a Democrat, and South Carolina's Lindsey Graham, a Republican — introduced an amendment that would slap a 27.5% across-the-board tax on everything imported from China, unless Beijing agrees to end its policy of pegging its currency, the yuan, to the U.S. dollar. The theory is that, without the peg, the yuan would sharply rise in value, making Chinese exports less attractive on world markets and U.S. exports more attractive. For several years the Bush administration has been urging China to eliminate the yuan peg, and it's been turning up the volume in recent months. But the Schumer/Graham amendment escalates the negotiation to a whole new level. Threatening to slap huge tariffs on a major trading partner is truly a thermonuclear option — one that would have disastrous effects in China, the U.S. and around the world. It's not in anyone's interest to destroy the Chinese success story, nor to start a global trade war.
Stocks made their lows for the year on Wednesday when Schumer told the press that the president backs the proposed legislation. Bush and Treasury Secretary John Snow have since aggressively denied it, going so far as to say it would violate World Trade Organization rules. And that no doubt was part of the market's better mood on Thursday.
But there is real risk here. When the legislation was introduced in the Senate two weeks ago, opponents called for a motion to table it. The motion was defeated resoundingly, by 67 to 33, so Senate leadership has had to promise to bring it to full vote by the end of July, and similar legislation is being concocted in the House. Sen. Graham claims there's a "wildfire" in Congress to rein in China's mighty export machine.
If that wildfire doesn't get controlled, and the Schumer/Graham amendment gets enacted, would Bush sign it into law? He's said he's opposed. He's said it violates WTO rules. But then again, this is a president who has never vetoed anything. This is the president who signed Sarbanes-Oxley, perhaps the most destructive antigrowth law of the past two decades. And even if he did veto it, the votes for a congressional override might be there.
The best hope is that China will "voluntarily" take steps toward ending the peg. Indeed, Bush broadly hinted this week that such a thing was a possibility. And that's just how I think it will play out. The only thing that's stopping China is pride. After all, no self-respecting nation wants to be seen as having its economy at the command of foreign politicians. But for diplomats, there's always a way to preserve one's pride.
Besides, what's there to be proud of in pegging one's currency to the dollar in the first place? Talk about having a foreign country run your economy!
Yes, the peg has certainly served its purpose. Sticking to it doggedly for more than 10 years has given China a lot of credibility. But while the protectionists in Congress think it will harm China to drop the peg now, I think it's actually in China's interest to do it. In fact, Alan Greenspan said the very same thing this week.
He should know, because he's what's wrong with the peg. By pegging the yuan to the dollar, China imports all of Greenspan's mistakes. It imported his deflation in the late 1990s, and it's importing his inflation right now. At this point, China is better off going it alone.
My bet is that sometime between now and the end of July China will announce its first step toward ending the peg. It won't do a darned thing to stem Chinese imports into the U.S., or bring back unskilled jobs for American workers, or cure the U.S. merchandise trade imbalance with China. Why? Because the yuan was never the reason for those things in the first place. But when that happens, stocks will soar since the risk of truly insane protectionist legislation will be off the table.
I'm no Pollyanna. I see all the risks out there. I just think they're all going to turn out fine. And even if they don't, stocks are so cheap I'm not worried that I'll lose a whole lot either way.
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com4.
The Technician (escapades at times as Carnac)
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