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Lawrence Kudlow: A Bullish Case
08/27/2004 12:00 am EST
Since his days as associate director for economics and planning under President Reagan,Lawrence Kudlowhas played a dominant role in the finance arena. Today, as host of Kudlow and Cramer, he remains one of the most popular business figures. Here's his latest.
"For whatever reason, in its wisdom, the stock market, which has been slumping this year, is really pricing in a pronounced slowdown in economic growth in the future—and presumably in profits as well. I think that is the biggest message from the markets. As I talk to guests and CEOs who come on our Kudlow and Cramer show, there has been a shift in expectations to a much slower rate of economic growth in the next year or two, and along with that, a decline in profits, or at least a slowdown in profit growth. I might add that two-thirds of the market correction has come since the Fed raised its target interest rate on June 30. As an aside, I think we should replace the Fed with a computer, but that’s another matter.
"Is the market right? Well the market is always right. It is what it is. But let me take this opportunity to second-guess the market’s wisdom. I believe we are in the very early stages of another long prosperity cycle. Since 1982, we’ve only had five negative GDP quarters. That’s pretty darn good. Even with the collapse in the market a few years ago, stocks have done handsomely. In fact, the economy itself has grown, on average, by about 3.5% a year with about 2.5% inflation and a big slide in interest rates. That is a very enviable record.
"This an economy characterized by a lot of economic freedom— freedom to keep more of what you earn, freedom to make your own decisions in business, freedom to keep you wealth in savings, etc. And this has made a huge difference and is why we have outstripped the Europeans and the Japanese. The great news is that in terms of the revolutions around the world that have occurred in the last 20 years, in places like Russia, the Baltics and Eastern Europe, China and in India, they are borrowing the American model of economic freedom, which gives them an opportunity to catch up after being mired for so many years. As long as the United States doesn’t turn away from its own model, we should continue to do very well and what we are seeing now should become a rather brief and forgettable stock market correction.
"Just in the past year or so, the policy mix turned strongly pro-growth. We had a good reduction of tax rates, especially aimed at capital formation and investment. The reduction on the double tax on dividends and on capital gains as well as the acceleration of the income tax cuts triggered a rebound in the economy. In addition, the Federal Reserve has been cooperative in accommodating the cash demands of the economy. It’s very important that the Fed put the dough in so that the wheels of commerce and investment can be appropriately greased. And they have added money supply and they have kept interest rates down. This is a good thing and we’ve grown about 5% since the spring of 2003. Prior to that we were mired in the 1% to 2% growth range. So I view this as a very favorable pro-growth mix.
"Let me add, we’ve also had a terrific rise in productivity. If we can grow our rate of productivity in the US by 3% per annum in the next ten years as we have basically in the last ten years, and if you apply normal labor force growth, that means our economy's potential to grow is not 2% or even 3%— its over 4% a year. That means we don’t have to fret over inflation until growth is somewhere over 4%. Interestingly, between 1995 and 2000, during the height of the boom, our growth rate was about 4.25% per year. And during that time, inflation came down as the stock market went up. By and large, profits outperformed expectations. I’m My point is a simple one: less you be too pessimistic in this market correction, try to keep this longer term vision as clear as you can. We have low tax rates, we have low inflation, and we have high productivity. What should happen going forward is that growth will outperform expectations. Profits will come in higher than expected. And on the flip side, interest rates and inflation will come in lower than expected. I believe business investment will, on average, grow faster than consumer spending, which is terrific.
"Because of the emergence of two new tigers in Asia—China and India— who are themselves liberalizing their economies, economic growth will be very rapid in that part of the world. This is a good thing with many good consequences, not the least of which will be for the first time in our modern professional lifetimes, the American trade deficit and the American current account deficit is going to come down a lot. Why? Because with numerous free trade agreements in place, we can sell our export goods and services and it will be the best new markets we have had since WWII when we rebuilt Europe. So, hopefully, in addition to good growth and earnings, we will see a terrific improvement in our trade balances. Meanwhile, lower tax rates make it more profitable to save and invest. The tax cut case is essentially borrowing the growth models of JFK, who lowered tax rates across the board in the 1960s and Ronald Regan who lowered rates in the 1980s. I believe those two outstanding growth periods will be emulated in the first decade of this new century.
"There are issues out there. There are always issues out there. Oil is a big issue. Terrorism is a big issue. Elections are an issue and the Fed is an issue. On oil, I’m something of a contrarian. I think oil is the least of our problems. This is not—contrary to most of what you read and hear— a 1970s oil shock. The 1970s oil shock was born from supply shortages. They were deliberate supply shortages by the Arab OPEC cartel, which in those days were our strong enemies. Also, there were shortages of energy due to bad government policies such as wage and price controls, oil and energy excess profit tax, etc. The oil shock today is a demand side oil shock. By that, I mean, world economic growth is rising. Oil is now much more like a normal commodity.
"What will happen in the next few years, as a result of high energy prices coming from the economic boom in the US and in China and India is that more capital will be invested in energy sectors. Markets work. And as more capital is invested, we will produce more and the supply-demand imbalance will begin to level out. You will be surprised at how much energy we will produce. And it can be natural gas, oil, nuclear, coal. It may be hybrids. We may see a bid change in the automobile industry. The incentive system will work. I’m not really worried. The media likes to make oil a problem. It sounds bad, which sells ads for cable stations and newspapers. The media loves to remind us of the bad old days of the 1970s. This is not the 1970s— not in terms of regulations, or taxes, or the ability for free markets to work through corrections. So, I’m not so worried about oil.
"I am worried about the Fed. I’m hoping the Fed will do it right, just as I have hoped for the whole 30 years of my career. I’m not here to bash the Fed, which rarely gets it right, but I would like to give you a way to 'read' the Fed. I believe the Fed was the single biggest factor in the crash of 2000. I think Mr. Greenspan, who is a very brilliant man, has allowed his policies to be guided by the markets. But I think he got into a lot of trouble in the late 1990s and he lost that discipline. Here’s what happened. In 1999-2000 as the Fed was tightening and raising interest rates— for reasons that are still beyond me, as the inflation rate never got much above 2%, gold prices were collapsing, and commodities were collapsing.
"Perhaps most importantly, the structure of interest rates was turned upside down on its head. Short-term rates were higher than long-term rates. This is called an inverted yield curve. Whenever you see that, it is a classic signal of a liquidity squeeze, a deflation and a recession. Always. It is one of the best indicators there are for recession-recovery watch. It’s also a great stock market indicator. You could have looked in early 2000 and seen the Fed raise its target rate in January and again in March, and then the killer was in May. Treasury rates in the long end fell, and short rates rose. If you had used that to time the market, you would have done very well by selling when you saw the inverted yield curve.
"What about today? I am hoping the Fed will back off and make signals that they can go slowly and that people don’t have to worry about an unwanted liquidity squeeze returning anytime soon. Keep you eyes on that yield curve. If it goes upside down again, I’m telling you—even an optimist like myself would have to take some time out for a short while. If they keep it where it is, or maybe a little flatter. Right now, the spread is about 300 basis points wide. Treasury bonds are about 4.5% on the ten-year and the Fed is 1.5%— so call that three full percentage points. That could shrink to 2 percentage points and that would be okay. But if it goes beyond that, you may have problems. So that’s one thing to watch.
"One simple and profound view of money—known as the Wicksell yield curve and discussed since the early 1880s—is that there is a natural rate or 'real rate' in the economy. That’s the rate at which we can invest and consume and whenever the central bank’s policy rate is above that natural rate, that’s a recession-deflation signal. Whenever it’s below that, it’s an inflation-recovery signal. You can chart the so-called natural rate through the marketplace— through the inflation adjusted Treasuries, or TIPs. That’s the real rate. It is today at 2%. The policy rate is at 1.5%. So that’s good. They can raise that rate to 1.75%. But the minute they cross over and the Fed funds rate is above the natural rate, that is a problem. That is a negative for the economy. And if you had used this discipline in early 2000, you would have gotten out. W atch the two yield curves— the Wicksell yield curve and the Treasury yield curve. They will help you decide.
"In my opinion, I think interest rates will be much, much less of a threat than people think. We grew at 4.5% last year. I think we’ll grow at 4.5% this year and 4.5% next year. I doubt the inflation rate will be much above 2%, and to me, that makes the stock market very cheap. In relation to bond-land, stocks are undervalued by at least 20% - right now. So as the market corrects downward, I would be a buyer. Car sales are picking up, consumer confidence is picking up, and profits will come in about 30%, year on year. Yes, profits will slow as they always do. But that’s fine as long as the level of profits is still rising. That opens the door for stocks to rise.
"I would be buying growth sensitive— technology, industrials, financials, consumers, and especially energy. I like refiners; I think that’s a great place to be as we try to produce more usable fuel. So I would just be sweeping in these stocks. And while I don’t pick specific stocks, I would note that exchange traded funds are a cheap way to have diversified positions in these groups. Let’s take an interesting group such as biotechnology. I love biotech. It combines all the innovations in technology with our medical advances. But I would hate to try and select one company. But there are a hundred of more companies that you might want to flirt with on the chance that they come up with a drug. The best way to play this is to buy an ETF, which mimics the Biotechnology Index. Overall, exchange traded funds are a great way to have diversified portfolio of stocks in separate sectors."
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