Random walk: Wall St.

THE stock market's Thanksgiving-week turkey performance (the Dow Jones index dropped 107 points) provides yet another warning that the cyclical bull market that started in early 1991 may be coming to an end. So far this year, the average of four major market indices has declined by 3.5 per cent, compared to gains of 20 per cent or better in the prior three years. Small-cap indices such as Nasdaq and the Russell 2000 have posted an average 5.4 per cent decline, while the Dow and S&P 500 have averaged a 1.6 per cent drop. When the more volatile smaller caps underperform the larger ones, it often signals a growth slump or outright recession. This year's relative performance is the opposite of what happened in 1991-93, when the smaller-cap indices outperformed the big guys, thus correctly signaling stronger future economic growth. So far this year, investing cash in three-month Treasury bills--with an average return of about 4 per cent--would have been the best bet.

Market historians note that an average bear market brings stocks down by roughly 20 per cent. So will stocks drop another 15 per cent or so? They could. One way to look at the issue is to compare the earnings yield of stocks (current company earnings divided by the current price) with the yield on gilt-edged Treasury bonds. Ten-year Treasury note yields over the past 12 months have jumped 50 per cent, from 5.2 per cent to 7.8 per cent. But the earnings yield for the S&P 500 has risen by just 36 per cent, from 4.4 per cent to 6 per cent. Unless Treasury yields fall significantly--an unlikely event if the Federal Reserve keeps raising interest rates--this implies a further stock-market correction of 14 per cent.

Another way to measure the market's downside risk is the interaction of the inflation rate with the unindexed capital-gains tax. If the yearly inflation rate rises to 3.7 per cent from its low of 2.7 per cent, the effective tax rate on real capital gains would jump to 62 per cent from 53 per cent. This means taking home only 38 cents on the inflation-adjusted dollar instead of 47 cents, a 19 per cent drop. Since the stock market represents the present discounted value of future wealth, an inflation-induced drop in the after-tax value of wealth and capital is sure to knock down share prices.

Finally, until Newt Gingrich and Bob Dole actually reduce the capital-gains tax, perhaps in a bullish vote sometime next summer, we are still paying for Bill Clinton's tax hike on those with the highest propensity to save and invest. By raising the effective top marginal tax rate on income from 31 per cent to 43 per cent, the 1993 budget deal reduced after-tax income to 57 cents on the dollar from 69 cents, a loss of 17 per cent of investable stock-market resource flows.

In other words, high interest rates, rising inflation, and past tax hikes spell continued trouble for the stock market. I told you a few months ago that cash looked very sexy to me. I am still in love.

* In the 1980s, anti-supply-side theorists such as Robert Reich and Lester Thurow argued that the budget deficit and the trade deficit were mirror images of one another. For a short while, the data seemed to corroborate the "twin deficits" theory. From 1981 through 1986 the budget deficit and the balance-of-payments deficit did indeed rise in tandem. As the budget deficit climbed from $80 billion in 1981 to $220 billion in 1986, the trade deficit grew from zero to $145 billion. But economists Mickey Levy and Peter Kretzmer of NationsBank report that from 1988 through 1991 the budget deficit rose, while the trade deficit fell back to near zero. In 1993 and 1994 the budget deficit fell and the trade deficit skyrocketed.

"Our assessment," Levy and Kretzmer write, "is that the U.S. trade and current-accounts deficits of the 1990s have different sources and characteristics than those of the 1980s." In the 1980s, the high trade deficit was caused by pro-growth tax policies and Reagan's transition to a low-inflation monetary regime, which generated a huge rise in the rate of return on dollar-denominated assets, a surge in the demand for investment capital, higher real interest rates, a tidal wave of foreign investment in the U.S., and a mightily strong dollar.

By contrast, the Clinton Administration's fiscal policies of high taxes and defense cutbacks have contributed to a large trade deficit and a much less sanguine set of corresponding economic trends: an anemic dollar, sharply lower relative expected returns on dollar-denominated assets (witness the sputtering stock market), and a stampede of investment capital seeking refuge outside the borders of the United States.

This, of course, is precisely the opposite of what was expected. When Reich, Thurow, et al. peddled the twin-deficits hypothesis in the 1980s, they routinely promised that a tax increase would reverse the trade imbalance, lower interest rates, raise the rate of national savings, and expand domestic investment. All of this goes to show that ever since Reagan left town the most important deficit in Washington has been the deficit in understanding how the world really works.