The market is full of mysteries. Here we are with the yield on 10-year Treasurys falling below 4%, and everyone’s saying that’s because the bond market is predicting a recession. Yet — Friday’s reversal notwithstanding — stocks have just rallied for the fifth week off their April 20 bottom, with the S&P 500 now up 5.9% and the NASDAQ 100 up 11.5% since then (through Thursday).
On Wednesday, when the ISM manufacturing index showed that factory business in the US was slowing even more than expected, stocks had a huge day. So what’s going on? Do stocks suddenly love the idea of a recession? Gee, if that’s true, then think how much stocks would rally if we had a depression!
The conventional wisdom on this seeming paradox is that a weakening economy means the Federal Reserve will stop raising interest rates. Lower rates mean the economy will be stronger, and that’s good for stocks. Huh? A weakening economy means a stronger economy? I suspect the conventional wisdom is not all that wise in this case.
There are better explanations for why stocks are rallying. Some of them will be very familiar to readers of this column.
First, stocks are cheap. I’ve said it before, and I’ll say it again. Based on corporate earnings yields compared to the income yield of bonds, stocks are as cheap as they’ve been at any time during the last two decades, with the exception of the very day of the bottom in October 2002.
That means one important thing to investors: If all the doom and gloom about recession and depression comes true, stocks don’t have very far to fall (because they’ve already fallen). But if there’s even the slightest lift in the doom and the gloom, stocks will zoom.
Second, stocks have rallied because all the technicals have been in place. My colleague Fred Goodman, the outstanding technical analyst who writes a daily report for my web site, gave an intermediate-term buy signal about a week before the April bottom, and called for investors to take leveraged positions in stocks. He’s up 3.9% in the S&P 500 and 12.2% in the NASDAQ 100 since he made that call.
Third, there’s politics. You knew I was going to eventually get to politics, didn’t you?
Stocks like it that the initiative for Social Security reform is now in the hands of House Ways and Means Committee Chairman Bill Thomas (R.-Calif.), a man who understands that you can’t solve the problem by raising taxes. In fact, the current rally started the very day he took the reins.
And stocks like it that President Bush and Treasury Secretary John Snow are taking it slow and steady in demanding that China reform its currency, the yuan. The last thing we need is for a trade war to escalate out of control, as it looked like it might do in early April when the Senate introduced legislation to slap a 27.5% tariff on all imported Chinese goods.
The political factor that’s been most responsible for this week’s stock-market action has been a sudden burst of progress on the regulatory front. I’ve written here many times about how the economy has been held back by excessive new regulations — the draconian burdens that Sarbanes-Oxley imposes on all public companies for the transgressions of a very few, and the risk that overhangs every American corporation that the next phone call it gets might be from Eliot Spitzer, Grand Inquisitor — oops, I mean attorney general — of New York.
This week’s developments in regulation have a certain irony about them. On Tuesday President Bush gave a press conference, in which he was asked about the conviction of Russian oil tycoon Mikhail Khodorkovsky on charges of fraud and tax evasion. Bush said, “here you’re innocent until proven guilty, and it appeared to us…like he had been judged guilty prior to having a fair trial.”
And then just a few moments later, it was announced that the Supreme Court had overturned the conviction of accounting firm Arthur Andersen for destroying documents in connection with Enron. Talk about “judged guilty prior to having a fair trial”! Prejudged guilty in the press and the halls of Congress, Arthur Andersen was stampeded in a show-trial in which the high court found that the judge’s instructions to the jury failed to call for the required proof that Andersen knew its actions were wrong. No, it’s better than that. The Supreme Court was unanimous. And in his opinion, Chief Justice Rehnquist wrote, “it is striking how little culpability the instructions required.”
Cold comfort for 28,000 Andersen employees whose lives were ruined in this Alice in Wonderland perversion of justice (as the Red Queen demanded, “First the sentence, then the evidence!”).
But it gets even better. The next day brought the resignation of Securities and Exchange Chairman William Donaldson, who’s been responsible for two years of intense regulatory harassment of public companies. The only times Donaldson hasn’t been openly cooperating with Spitzer in carrying out anti-business lynchings is when he’s been trying to out-do Spitzer, to be even tougher on “corporate crooks.”
Wait, though, it gets better still! On Thursday, Bush nominated Donaldson’s replacement, conservative Rep. Christopher Cox (R.-Calif.). He’s a pro-business and pro-growth guy all the way, and if his confirmation process doesn’t reveal that he’s failed to pay taxes on his illegal alien nanny’s pet fish, he’ll be a sensational SEC chief. He’s just the kind of man who will have the courage to fight a lynch mob rather than join it.
Longer term, with Spitzer destined for the New York governor’s mansion where he can’t do any harm for a while, we could be looking at a regulatory climate that’s a lot friendlier for business.
Let’s just begin to think about what a world without the overhanging threat of a regulatory lynch mob might look like. You know that record level of cash corporations are hoarding? They don’t want to say it out loud, but they’re hoarding it to pay the enormous fines that Spitzer and Donaldson have been able to extract from companies, usually without the formality of a trial.
Of course that cash is one of the things that attracts people like Spitzer and Donaldson to their targets in the first place, like a bulging wallet and a gold Rolex attract a mugger. But what are you going to do?
How nice if companies didn’t have to worry about that kind of thing. Think of what they could do with the cash. More capital expenditures on research and development. Or maybe even higher dividends for investors and higher salaries for workers — the very people the regulatory muggers claim to be protecting.
No, stocks didn’t go up this week because we’re heading into a recession that will keep us from heading into a recession. They went up because maybe, just maybe, we’re coming to our senses about what it takes to let business do business again in this country.
The above is an “Ahead of the Curve” column published June 3, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.