Omnimax Vision

So far in this column, we’ve zeroed in on smaller,
sector-specific pictures — anthrax macroplays like Surebeam Technology
(
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PowerRating),
war-game macroplays like Pemstar
(
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PowerRating), and homeland security macroplays like
Pec Solutions
(
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PowerRating). This week I
want to flip the telescope over and look at the biggest possible picture.

This “Omnimax vision” may not help you turn a profit
this week or even next, but this ultimate macroplay on the broad market trend
may be the most important piece of information I will ever share with you. So here’s the question, and it is based on a very lengthy report I
issued last week from the Milken Institute on the economic costs of terrorism. 

How will the worst terrorist attack in U.S. history
affect the volatility of the stock market cycle and long-run prospects for a
sustained bull market? To parse
this, let’s examine four key macroeconomic variables in the accompanying chart
for the bull market days of 1993 to 2000 and the very bearish times of 1974 to
1982.

Key Macroeconomic Variables in Bad Times and Good

 

From 1994 to 2000, the U.S.
economy demonstrated its full potential in a world of very low inflation,
reduced demand for military goods and services, and the rapid diffusion of
exciting new technologies. Comparing
this period to 1974-82, productivity growth was substantially higher: 2.14%
vs. 0.88%. Inflation was virtually nonexistent: 1.85% vs. 7.84%. The unemployment rate was remarkably low — less
than 5% compared to more than 7%. And the economy grew, in real
terms, twice as rapidly as in the 1974-82 period.

Now consider this: The very bad
times of 1974-82 were initiated by an over-expansionary fiscal policy in the
1960s, and compounded by numerous supply-side shocks in the early 1970s. The
risk today is that we are witnessing the beginning of a similar series of
destabilizing forces that could ultimately bring the stock market crashing down.
Here’s the nightmare scenario:

Over the next several quarters,
the macroeconomic shocks of the terrorist attack — lost production in the
immediate aftermath of the attacks, plunging consumer confidence and a sharp
drop in retail sales, a dramatic reduction in business investment, a negative
“wealth effect” from a declining stock market — all conspire to push the
U.S. economy into a deeper and deeper recession. During this stage, the Federal
Reserve responds with a radically expansionary monetary policy, while the
President and Congress provide a huge dose of expansionary fiscal policies —
from the bailout of the airlines, aid to New York City, and increased defense
expenditures to tax cuts.

Collectively, this stimulus on
steroids pulls the economy out of the recession at a rapid pace — the vaunted
“V-shaped” recession — but sets the stage for increased inflationary
pressures. Within perhaps a year or two, the economy overheats in much the same
way the economy did in the late 1960s during the Vietnam War. At the same time,
massive expenditures on increased domestic security needs create additional
downward pressures on productivity in much the same way that new environmental
and workplace regulation did in the 1970s.

Now here’s the punchline: If,
in this scenario, the GDP only grows at 2% a year like it did in the 1970s
period instead of 3.5% (a half a percent less than in the 1994-2000 period), the
annual lost GDP by the year 2011 will be a staggering $2 trillion! That’s not only a recipe for huge budget deficits and a more rapid
collapse of the social security system, it’s also a prescription for a
sustained bearish and stagnating stock market.

So can this scenario be avoided? 
Yes — but only if the President and Congress follow the advice that
Federal Reserve Chairman Alan Greenspan offered in the immediate aftermath of
the Sept. 11 attack. In
the matters of fiscal and monetary policy, he said with uncommon conciseness —
“It’s better to be right than quick.”

As for whether the worst-case
scenario may find us, the best clue will be to carefully watch the “yield
curve” which describes the relationship between short-, medium- and long-term
interest rates. Any sign of a sharp
upward movement of the long end of the curve will be a signal of inflationary
concerns. (More about this in a
future column.)

Note: The lengthy report on the
economic costs of terrorism that this article is based on is available at https://www.peternavarro.com
— lower left hand corner of site. Check
it out.