- The Washington Times - Tuesday, August 27, 2002

As the summer winds down, certainly all is not lost on stocks and the economy it's just that things aren't as good as they should be. The major stock averages are up 17 percent to 20 percent from the July 23 low. We'll all be thankful for small gifts. The latest S&P; earnings are up 3.5 percent from a year ago. On an earnings-per-share basis, they are up 13 percent.
With our fingers crossed, shares could have another 10 percent or maybe even 15 percent for the year. Maybe. Holding back the market and business is a continued corporate credit crunch and balance sheet deflation. Debt burdens have increased, while asset values have declined. Real corporate bond rates are still high, and quality spreads relative to the 10-year Treasury are still very wide.
The good news? BAA corporate bond rates in the open market have descended to 7-1/2 percent from 8-1/2 percent. This is a big positive that has undoubtedly nudged stock prices higher. But in the high-yield distressed bond sector, yields remain very high and spreads against the Treasury are very wide. Gradually, investors will stop loaning the government money at 4 percent and start loaning to corporate America at more than double the return. But it will take time. Look for corporate bond prices and stock prices to rise or fall in tandem.
On the Fed front, money is still not sufficiently accommodative. The liquidity spread between the two-year note and the fed funds rate is much too narrow. High real corporate bond rates need additional liquidity from the Fed. They should decontrol the funds rate target and pump in plenty of bank reserves. Gold should be $350 or higher. The liquidity spread should be 200 basis points, not 25 basis points. Industrial commodities should be rising, not falling.
Dollars are being soaked up rapidly by cash-strapped companies and risk-averse investors. Dollars are also being drained by Latin America, which is imploding. The Fed needs a broad international context to understand what must be done.
Misery loves company, and Europe is in even worse shape than America. Japan is closer to Europe than America. The euro is too high. Oil is too high. U.S. Treasury rates are too low. Japan lacks the political will to implement broad-based tax, trade and banking reforms.
Paul O'Neill should be ashamed of himself, flip-flopping on Brazilian bailouts and turning policy over to the anti-growth, devaluationist IMF. Latin America is a basket case, a mass of impoverishment that is a ripe breeding ground for America-threatening drugs and terrorism.
Can the Fed handle deflation? The ECB across the pond is doing even worse. At least housing prices in the United States are rising the same cannot be said for Europe or Japan. U.S. deflation is manageable if the Fed pumps in a lot more cash. But Europe is a riskier deflation bet.
The November elections will be dominated by two big domestic issues. One, the investor class wants to see perp-walks from corrupt corporate chieftains. Two, the investor class wants to know how Washington can help their 201(k)s become 401(k)s and then 801(k)s.
If President Bush proposes significant dividend tax relief for corporations and individuals, it will be a home run. A big step up in the capital loss deduction would be a grand slam home run if coupled with dividend relief. That still leaves Saddam Hussein and the war on terror.
The Justice Department will be moving to Houston to finish the Enron story. From Kopper to Fastow to Skilling? Wait and see. Perps, tax-cuts and a rising stock market could win the Senate and the House for the GOP. Without that, Charlie Rangel may get his dream: Ways and Means chair at last.

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