Stock markets fully recover from Sept. 11

Larry Kudlow
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Posted: Oct 16, 2001 12:00 AM
In a surprising twist to the stock market recovery since the 9/11 terrorist bombing, the beaten down technology sector has actually led the way. Overall, technology-related shares have appreciated over 3 percent, compared to a slightly less than 2 percent gain for the S&P 500. The tech rally even includes communications equipment makers, who were absolutely crushed during the 18-month bear market rally. Some market gurus are scratching their heads since tech companies are reporting huge earnings drops and the tech sector is just about the worst performing area in the recessionary economy. But markets look forward, not backward. And one development that augurs well for future tech performance is a supply-side tax-cut that will cash expense 30 percent of business depreciation allowances for the purchase of new plants and equipment, especially technology equipment. While Democrats in both the House and the Senate are still waging class warfare on upper-end income taxpayers and capital gains-sensitive investors, there is a miraculously bipartisan consensus developing on the need to help the hard-hit business sector, which has led the economy downward over the past year. The timing of this tax change couldn't be better. Massive technology spending in the 1999 run-up to Y2K was borrowed from 2000 and 2001. By next year, however, obsolete tech equipment will need to be replaced, and accelerated write-off will make it cheaper for businesses to purchase new equipment. This, in turn, will allow business equipment manufacturers to reduce their selling prices. It's win, win. Investment in the hi-tech sector was the major impetus for economic growth during the 1990s. Real investment in information-processing equipment and software contributed about 20 percent of GDP growth; including capital spending on industrial and transportation equipment, then real business investment contributed nearly one-third to economic growth. By early 1999, tech sector capital spending surpassed industrial investment. Productivity growth surged as a result of the "capital deepening" investment from less than 1 percent to almost 4 percent. However, technology has been the hardest hit sector in this economic slump. Technology investment declined at a 19.5 percent annual rate in Q2 after a 12.4 percent decline in Q1. The monthly manufacturing data suggest that the Q3 drop will be just as grim. This decline in hi-tech spending will exacerbate the slowdown in productivity growth. Reviving investment in this sector is critical to resuming the productivity-led growth, but this will not be a quick process. The most recent monthly manufacturing data on computers, semiconductors and communications equipment, the hi-tech sector proxy, showed that the inventory-sales ratio hit a 5-year high in August. The I/S ratio in tech has now increased five straight months, and nine of the past 11 months. So, no tech recovery is yet in sight. While inventory has dropped (23 percent annualized 3-month decline), shipments have dropped much faster (50 percent 3-month drop). When the tech inventory overhang is finally cleared out next year, the cash-expensing tax incentive will provide significant impetus to a new round of hi-tech activity. Accelerated depreciation schedules reduce the effective tax-rate on technology production -- just what the doctor ordered. Congressional tax writers have a lot more work to do in order to nurture a strong economic recovery. War-related risk and uncertainty premiums are extraordinarily high, posing a tall barrier to growth. Investors and businesses must therefore have greater after-tax rewards in order to hurdle over this obstacle. That is why significant capital gains tax relief and accelerated income tax relief, including the top marginal tax-rate, are both necessary to revive animal spirits. But certainly the shortening of depreciation schedules for business capital spending is a positive development coming out of the House Ways and Means committee mark-up. In this cautious environment it must pay more, after tax, to invest and produce. Rather than ineffectual consumer tax rebates, lowering the tax cost of production and raising the after-tax return to investment will produce a real increase in consumer purchasing power. That is, of course, what the forward-looking stock market rally in techs and other sectors is telling us.