Churning, not burning

Larry Kudlow
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Posted: Mar 04, 2004 12:00 AM

The stock market is churning toward a correction, perhaps in the range of 5 percent to 10 percent. Behind this churn downward is the dollar's adjustment upward. And it's nothing for shareholders to fret about. In fact, with the economy so hot, it's a great opportunity for investors to fatten their portfolios -- and also a good time to reflect on why the economy is doing so well, and what will keep it going.

Since mid-February, the greenback has risen about 4.5 percent relative to the yen and 5.5 percent versus the euro. This is likely the beginning of a long-term move for the dollar based on high investment returns from the white-hot U.S. economy. It's ultimately a positive move, but one that will slightly moderate the Federal Reserve's intense reflationary policies. Indicating this, gold, which peaked in early January at $426, has since dropped $34, or 8 percent, to $392.

But again, there's no reason to fret.

Barring unforeseen external shocks, it may very well be that an 8 to 10 year non-inflationary boom cycle was launched last spring following the passage of President Bush's deep tax cuts on capital formation. Reducing high marginal tax rates on dividends, capital gains, small businesses, and all income earners has lowered the cost of capital and raised investment returns by roughly 50 percent.

That's an extraordinary reform. The U.S. economy jumped almost immediately to a 6 percent growth rate following the Bush tax cuts, ending an 18-month streak when growth was a lackluster 2 percent. This year, economic growth looks to be around 5 percent, with a continuation of the profits-surge that has driven up broad stock averages by nearly 50 percent and the tech-driven Nasdaq by 80 percent.

Since their bottom, after-tax corporate profits have jumped 73 percent. This has contributed to a record 10 percent profits share of gross domestic product. Corporate retained earnings, the ultimate seed-corn reserve for business, has rebounded a monstrous 213 percent.

Inside the economy, surging profits and record productivity, combined with supply-side tax cuts, have led to a new capital-goods investment boom. Over the past three months alone, durable-goods shipments have roared ahead at a 27 percent annual rate, a much more rapid pace than consumer-spending growth, which is still healthy at roughly 4 percent.

This neatly shows how the investment side of the economy is rising more rapidly than the consumption side -- that is, supply is growing faster than demand. It also underscores the fact that inflation is not a serious threat. While export sales to the rest of the world are rising at a torrid 21 percent pace, core inflation is a scant 0.7 percent over the past year.

All these key economic themes -- lower tax rates, a rising dollar, high productivity, surging profits, rapid recovery in capital spending and strong economic growth -- will work to hold back inflationary pressures. If inflation is caused by too much money chasing too few goods, then more goods available to absorb the existing money supply will hold down inflation.

And that's why a brief stock market correction should be a buying opportunity for investors. Growth-sensitive stock groups such as tech, basic materials, industrials and consumer cyclicals may pause to gauge the degree of monetary restraint caused by the rising dollar. But equity values over time will benefit enormously from a steadier greenback, lower tax rates and strong economic growth.

Interest rates, meanwhile, will adjust slightly higher. But this upward move -- destined for later in the year -- will primarily reflect higher economic returns, not inflation. Consequently, small adjustments in the Fed's policy target rate should be viewed as a positive, normal, cyclical event.

The stock market has known much greater challenges than a rebounding dollar. This year, for example, the dollar adjustment will pale in comparison to the threat posed by Sen. John Kerry's presidential run. His anti-growth proposals to steepen tax rates and move toward trade and job protection would impoverish, not benefit, the American workforce. What's more, his long-time voting record in the Senate against defense and intelligence appropriations suggests that a President Kerry would weaken national security and safety.

Stock markets already jittered when Kerry's rise in the Democratic primary polls held front-page sway in virtually all media outlets. No wonder. Turning back the very tax cuts that ended the three-year investment and capital-formation downturn would be exactly the wrong economic medicine. So would pulling back on the successfully waged war against terrorism. On cultural issues as well, Kerry would reverse Bush's efforts to return America to the values found in traditional family life.

Spurred by the rising economy, Bush should win the November tally. But it is political risk, not interest rates or the dollar, that will be uppermost in the minds of investors.