Calming the Bear

I recently laid out in NEWSWEEK the bearish argument for why we should be very gloomy about the global economy, bearish about stock markets and deeply depressed about the world in general. I told readers it was my belief that there was a 50 percent chance that the world was facing a long cycle of recession, depression and wealth destruction. I maintained that the bears believe that the best-case economic scenario is Japan's agony since the 1990s, and the worst is a replay of the 1930s.

Since I wrote that piece, two things have happened. The first is that the global economic outlook has deteriorated—the market consensus now is that the angle of descent of the U.S. economy, as well as that of Europe and the major emerging markets, has steepened. Second, and even more disconcertingly, President Obama has announced what many investors consider to be a populist redistributionist tax agenda, which increases the tax rate on capital gains and dividends and gives tax reductions and distributions to the middle class and the poor. Neither event has buoyed investor mood.

Despite this, I still believe that there is a 50 percent probability of a happier outcome. The world is having the most severe recession of the postwar era, and the recovery will be sluggish and plagued by inflation. Nevertheless, the doomsday scenario of depression and deflation, with 5000 on the Dow Jones industrial average and 500 on the S&P 500, is farfetched. Markets could be on the brink of a major rally, and the U.S. economy may begin to recover later this year. Here are the reasons, in no particular order.

First, the financial panic and the collapse of the world economy caught the so-called Authorities (i.e., the central banks and the governments of the world) by surprise. They reacted slowly, but nevertheless far faster than the Authorities in the U.S. in the 1930s or Japan in the 1990s. In both those cases, the Authorities were not only tardy, but they also made serious policy errors, such as raising tax rates, imposing tariffs and not curing the banking systems. These mistakes are now well understood—the current Fed chairman has written a book on the subject.

This time around—and this is very important—the Authorities have unleashed powerful fiscal and monetary stimuli that are totally unprecedented in size and scope. Interest rates have been dramatically cut everywhere, and every week more countries announce new fiscal-stimulus programs. It takes time for these actions to affect economic activity. Rate cuts and expansion of the money supply are powerful medicine, but won't make a difference for at least a year. Fiscal programs are quicker, but also take time to implement. The actions of the Authorities should begin to boost activity by the late spring, and their uplifting effect will grow as the year progresses. In the United States, the fiscal-stimulus program is expected to add 4 percentage points to real GDP growth in both the second and third quarters of this year. In other words, the world economy should begin to level out and improve as time goes on. We are not in a hopeless death spiral, as the bears say.

Second, the bourses of the world have been falling since 2000 and, adjusted for inflation, are down 60 to 70 percent. The sorry state of the world economy is front-page news. Therefore, it stands to reason that the bad news is extremely well known and must be pretty thoroughly priced into the markets. Treasury bonds have vastly outperformed stocks for 10 years, and the relationship between the two is back to the level of the early 1980s, which was a fabulous buying opportunity for stocks; 1982 was the takeoff point for the greatest bull market in history. Bear in mind that for the entire 20th century, a turbulent 100 years, the annual real return for stocks in the U.S. was 6.9 percent, versus 1.8 percent for Treasury bonds. In Sweden the relevant figures were 8.2 percent per year versus 2.3 percent for bonds; in Germany, 3.7 percent versus minus 2.3 percent; and in Japan, 5 percent versus 1.6 percent. Why would you want to be a lender to the U.S. government rather than an owner of real assets or the means of production at a moment when the government is printing more paper than at any time in its history? Rolling more money off the printing presses always eventually means higher inflation and interest rates, which is, of course, bad for bonds.