NCPA - National Center for Policy Analysis

Market Poised for a Comeback

July 1, 2002

Not only must investors deal with almost daily revelations about cooked books at major corporations, but they also have to figure out whether the economic expansion is for real and why the dollar is falling.

  • Since the first of the year, the dollar has fallen about 5 percent against major currencies -- perhaps a harbinger of inflation (see figure).
  • That could cause the Federal Reserve to tighten monetary policy, and could put a damper on foreign capital inflows -- which has been important in fueling the stock market growth in recent years.
  • All other things being equal, the stock market should be a lot higher than it is now, given the strong industrial production, consumer spending and home sales.
  • Both the economy's and the market's problems resulted from the Federal Reserve's excessively tight monetary policy.

Among deflation's effects -- too many goods and too little money -- is crashing corporate profits. Companies invest in expectation of getting certain prices for their products. When deflation lowers prices, profits necessarily take a hit and stock prices fall.

  • The Fed recognized its mistake and aggressively eased monetary policy for a year and a half.
  • Under normal circumstances, we should have seen signs of a rebound just around the time September 11 hit -- and just as the effects of that blow wore off came the Enron scandal.
  • But September 11 and the Enron/WorldCom effect on earnings were one-time events -- once they're over, they're over.

If prices and exchange rates are only returning to normal after a period of deflation, then this is a good sign, not a bad one -- the final sign that a deflationary trend is finally over. Assuming there are no more terrorist attacks or WorldCom-type announcements, higher corporate profits and stock prices should follow.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, July 1, 2002


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