s 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% to 20% from the July 23 low. We’re all thankful for small gifts. The latest S&P earnings are up 3.5% from year ago; on an earnings-per-share basis they are up 13%.
With our fingers crossed, shares could have another 10% or 15% in them 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? Corporate bond rates (Baa) in the open market have descended to 7.5% from 8.25%. 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% and start loaning it 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 2-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 — or float it, letting it rise or fall to its own level — 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 political will to implement broad-based tax, trade, and banking reforms.
Paul O’Neill should be ashamed of himself, flip-flopping on Brazilian bail-outs 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? We’ll see. But the European Central Bank across the pond is doing even worse. While housing prices are at least rising in the U.S., 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 revalue into 401(k)s and perhaps even 801(k)s.
If President Bush proposes significant dividend tax relief for corporations and individuals, it will be a homerun. A big step-up in the capital loss deduction would be a grand slam homerun if coupled with dividend relief. That still leaves Saddam Hussein and the war on terror as GOP positives this fall.
Meanwhile, the Justice Department will be moving to Houston to finish the Enron story. From Kopper to Fastow to Skilling? We’ll wait and see. But the combination of perp walks, tax-cuts, and a rising stock market could win the Senate and the House for the Republicans. Without that, Charlie Rangel may get his dream: Ways and Means chair at last.