- The Washington Times - Friday, October 27, 2000

There are a couple of economic analysts out there who are obsessing over the recent peak to trough drop in the Nasdaq and other stock indexes. From this minuscule out-of-context reasoning, they are warning of a full-bore recession from the so-called negative wealth effect on spending. If no one has gone ahead of me, let me say it first: This is slipshod economic reasoning at its worst.

Actually, if there is a wealth effect on the economy, it's positive, not negative. Over the past 12 months the only meaningful context useful for economic forecasting purposes major market indexes are up, not down.

The Wilshire 5000, the broadest index, calculates a $1.2 trillion in additional new household wealth over the past 12 months. The narrow Dow Jones index may be flat over the past year, but the S&P; 500 is up more than 8 percent. The Nasdaq is up 22 percent. The Value Line index shows a 16 percent yearly gain. Even the small cap Russell 2000 is 16 percent ahead of last year.

Now here's another point. Let's keep profits in their proper context. Companies reporting a few cents below the expectations of securities analysts have been blown out of proportion. The proper context is year-to-year changes. Here too the overall story remains positive, not negative.

According to Joseph Kalinowski of IBES International, operating profits at the 249 S&P; 500 companies that have reported so far for the third quarter show 16 percent growth above year-ago levels. According to the IBES survey 141 firms or 57 percent have beaten consensus estimates. And don't forget that this year-on-year comparison is coming off last year's very high base where annual changes were running more than 200 percent.

According to First Call/Thomson Financial, share-weighted earnings growth is running 16 percent ahead of last year, while market cap weighted profits are up 20 percent.

Recessions don't occur while profits are rising. Profits are always the very heart of the business situation. Declining profits would force employment layoffs, production cutbacks and wage and salary declines, all of which accumulate into a business downturn. But expanding profits flag an expanding economy. That's the key point.

Whatever the day-to-day vagaries and vicissitudes of the stock market, which has been held hostage of late to Mideast tensions and the threat of disrupting oil price shocks, the fact remains that the overall corporate profits and stock market trends are still positive.

Context, context, context. Let's keep all this stuff in context.

There's no question the rate of advance of both the stock market and business earnings is slowing. The economy has had a few curve balls thrown at it. The tax-increase effects of Fed over-tightening, slightly higher core inflation (which has raised the unindexed effective capital gains tax-rate from 25 percent to 35 percent), and the temporary energy shock have all thrown a bit of sand in the economic gears.

But don't forget that rapid productivity gains are acting as a shock-absorber to cushion the impact of growth-slowing developments.

This is not the fragile unbalanced economy of the 1970s, where overinflation, overtaxation and over-regulation kept business conditions on a thin sliver by the water's edge. Instead, today's dynamic U.S. economy is backed by record technology investment, a solid wealth-creating incentive reward system and a super-strong king dollar that is capable of absorbing a few mild shocks.

Here's another key point. Gold is low and bond market rates have been declining since spring. This is completely unlike the 1970s. Ditto again for king dollar. These inflation-sensitive market price indicators are pointing to lower future inflation and future declines in the fed funds rate next year.

In a discounted-earnings model of stock market prices, falling interest rates boost the capitalized value of business profits. In other words, lower interest rates today raise the net present value of future earnings. This is why I am not surprised the stock market looks poised for a significant rebound, one that could take key technology stocks and the major indexes back to their old highs in the months ahead.

Here is a final point. Personal tax payments are rolling in at twice the rate of personal income, thereby exerting a tax drag effect on the economy. But judging by recent polls, the good common sense of working Americans is pointing to a George Bush victory at the polls.

Main Street people recognize that some fraction of the hundreds of billions of budget surpluses, which is the mirror image of the record tax payments, should be returned to the taxpayers who earned the money in the first place. Gov. Bush's broad-based marginal tax-rate relief plan has earned him a 10-point lead in the USA Today tracking poll and a 5-point lead in the Rasmussen Portrait of America overnight survey.

In his interview yesterday with CNBC's Ron Insana, Mr. Bush associated himself with Alan Greenspan's 4 percent estimate of the American economy's potential to grow. It is precisely this Reaganesque optimism that contains the attractive leadership qualities that should carry "W" across the finish line.

Keep the faith, investors. Better times are coming.

Lawrence Kudlow is chief U.S. investment strategist and chief U.S. economist at ING Barings LLC.

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