Bull Market Scenario, Reviewed Jude Wanniski June 3, 1981

Executive Summary: In July 1978, I sketched out a hypothetical path that would take the Dow Jones Industrial average from its then level of 800 to 3000 or 4000 by the early 1980s. In almost three years, the DJI has reflected the discouragingly slow movement along that path, which inclued a milestone of Kemp-Roth in 1978! The stock market is finally on the threshold of major advances as milestones appear close at hand and on the horizon, with a President who is eager to reach them.

Bull Market Scenario, Reviewed

In a special report published by H.C. Wainwright & Co. in July 1978, I outlined a scenario for a colossal bull market in stocks, one that would parallel the great bull market of the 1920s and carry the Dow Jones Industrial average to a fourfold increase in five or six years. The path to a DJI of 3000 or 4000, naturally, was the path through a revolution in the world of ideas, a revolution that would topple the "British" framework of mercantilism and Malthusianism from its position of dominance and elevate the forces of "youth, growth and dynamism." Although the term "supply-side fiscalism" had been coined by Herbert Stein, it was not yet commonplace in 1978 to refer to a "supply-side model" to describe the economic vehicle that would serve these dynamic forces as a framework for policymaking. The supply-side model, though, was implicit in the bull-market scenario, the policies flowing from it leading to the national and international wealth creation that would be forecast and discounted by the financial markets.

As in the 1920's, we can expect a gradual, then accelerating dismantling of the governmental barriers between effort and reward. An era of incentives. The most important of these barriers are the now unnecessarily high federal tax rates on capital gains, personal incomes, and gifts and estates. Also a dimunition of federal regulatory barriers to commerce. And a sharp reduction in the commercial costs that arise from doing business with an inconvertible dollar. My thesis is that these barriers will fall in series, not simply like a row of dominoes, but rather as logically as the play in an end game of chess -- after one player has gained such thorough dominance of the board that only gross error on his part can deny him the future.1

Almost three years later, the scenario has held up extremely well, but only in the sense that almost none of the policy milestones have been reached. In that "chessboard" struggle between the Black pieces and the White pieces, the White are clearly in a much stronger position now than they were in the summer of 1978. "White" has pushed "Black" out of the Oval Office. And this increased political strength behind the incentive/growth model has been sufficient to keep the bull market moving along; at least the probabilities have been increasing since 1978 that the enumerated policy changes will be implemented.

This has been nothing to scoff at. The DJI advance has been less than 20 percent from that July 1978 level. But the S&P 500 index has climbed by a third, from roughly 95 to the current 130s. In my initial scenario, I said that the Nasdaq index of OTC stocks would move more smartly at the outset if the Steiger Amendment cutting the capital gains tax rate did succeed in getting past Jimmy Carter. Carter was forced to swallow the amendment, which became the only major nourishment to the U.S. economy in the Carter years. Nasdaq's OTC index has covered considerable ground, moving from the 120s to about 220. The entrepreneurial ferment has, in turn, fed the less risky, but still young, energetic enterprises of the AMEX, which has had a dazzling run along the bull-market path, from an average 130 or so to the current 350s.

The scenario included passage of Kemp-Roth in 1978, although I said it was almost totally improbable that it would. The Democratic Senate and House served a close approximation, the Nunn amendment, also called "Son of Kemp-Roth." Carter sealed his doom in late October, 1978, by killing the program and, at the same time, ramming through Congress the extension of natural gas price controls. The DJI tumbled 100 points in the following few days. Had Carter not succeeded on these two critical policy decisions, he no doubt would have been re-elected. Ronald Reagan could not have scored with the question he posed in his televised debate with Carter: Are you better off now than you were four years ago? The answer would have been "yes," and the bull-market scenario milestone of a 1200-to-1400 DJI in 1979 would have been realized.

Since that key October weekend, there have been only three major economic policy changes that bear upon the scenario, two negative and one positive. In the fall of 1979, supply-side expectations were raised when Paul Volcker took over the Fed, based on his early tastes for a convertible currency. He quickly proved to be a profound disappointment, brainwashed by the Fed bureaucracy into becoming a manic manipulator of money through the open-market window and an ardent allocator of credit through the discount window. Passage of the windfall profits tax on domestic crude production was Carter's last sledgehammer blow to the economy, and with the combination at the Fed, the DJI was driven into the 730s on March 27, 1980 (although closing the day -- Bunker Hunt's "silver day" -- at 760). The third major policy change was President Reagan's decontrol of oii prices, a move that Leonard Silk of The New York Times for years had warned would cause terrible things to happen, including obscene oil profits. Silk now writes that Reagan is enjoying the "luck of the Irish" in having the exact opposite occur with falling real oil prices (and tumbling oil profits).

These three real policy changes have had the net effect of weighing down the economy; even oil decontrol, the one bullish move, automatically triggered higher tax rates through provisions of the windfall-tax legislation. We cannot count the President's success with Congress on the last Budget Resolution as a "real" change, because it after all was only a resolution, a promise to cut spending below the level it otherwise would have been. When the Congress in fact cuts the spending, the promise will have been realized - with beneficial effects on the financial markets.

What I am pointing out, in other words, is that here in June 1981 the policy cluster I outlined as fundamental to a DJI of 3000 or 4000 has, except for Steiger and oil decontrol, not been realized. And in addition, we have two major elements of what would be "A Bear Market Scenario:" Chairman Volcker and the "windfall tax." If it would not be for the market's assessment of the chessboard, and the possibilities of change in the months and years ahead, it could only see that we are in worse shape now than we were three years ago.Expectations of reality, though, approach reality. In my first review of the scenario, in March 1979, expectations were not high at all: "With the Carter administration still under the influence of the Phillips Curve, combating inflation by seeking lower growth, there remains the possibility that the U.S. will have to go through another pain threshold before policymakers stumble onto the bull-market track."

Expectations are very high now, but so have they been since November, yet as we approach the reality of policy change it seems to always recede into the distance. Kemp-Roth, which has been both the symbol and the cutting edge of the supply-side revolution, is five years old. Although the 10-10-10 across-the-board cut in personal income-tax rates was the centerpiece of the Reagan campaign, the only program that differentiated his economic agenda in the 1980 campaign, it remains on the horizon, treated as either a liability or a mirage. In December, Reagan said from his ranch that he was "itching" to get to Washington so he could cut taxes. Yet here at midyear, with Reagan as or more popular than ever and just as eager to enact Kemp-Roth, it seems almost as distant as it was in December.

In retrospect, the temporary stalemate was created by some minor Black pieces on the board -- the Wall Street business economists -- who managed to capture one of the most powerful supply-siders, David Stockman, early in the game. On the same day last December, Stockman came to Wall Street, just named OMB director, and met Henry Kaufman in the morning and Alan Greenspan in the evening, and he has never been the same. They implanted in him the idea that built their reputations, that gloom and doom will result unless austerity policies are followed. Their advice, echoed by Arthur Burns and most bank economists, has always been followed by policymakers, and when the squeeze is followed by higher deficits and interest rates, they simply argue that their advice was not followed, that there was not sufficient squeeze, and of course the result was as they predicted.

Stockman swallowed a variation on the theme. Kaufman-Greenspan sold him on the idea that the economy cannot expand unless there is a bull market in bonds and decline in long-term interest rates, which cannot occur unless the federal borrowing requirement is cut. He was thus pulled into the demand model, which posits a fixed supply of capital in the national pocket. If the government takes less out of the pocket, there will be more left for non-government, and with a fixed amount of bidding by non-government bond buyers for the remainder of the capital, interest rates would fall.

With this static picture in mind, Stockman concentrated his energies on producing a bond rally by reducing the government's borrowing requirement. It was Stockman who decided to defer consideration of the tax bill until spending was addressed in the budget resolution. Stockman then recommended postponing the effective date of the tax bill to July 1, and then further recommended postponing it to October 1. Stockman also recommended trimming the aggregate size of the tax cut, which effectively undermines Kemp-Roth's across the board provisions. And it was Stockman who dropped the Social Security bombshell into the midst of the debate. Each of the moves was designed to impress the bond market and win Henry Kaufman's plaudits, yet Kaufman relentlessly insists on more squeeze, higher taxes, and the bond rally will ensue.

The supply-side model that Stockman left behind concentrates on filling the pocket of capital, not carving it up to suit the tastes of Wall Street's bond traders. As a leading supply-sider in the Congress and in his first days at OMB, Stockman had argued that the deficit could not be reduced unless marginal tax rates were cut. But at OMB he became an old man fast, implicitly arguing for tax increases to reduce the deficit, through postponement of tax cuts. He even came to explicit tax-increase recommendations -- the end to the oil-depletion allowance - an argument scotched by the President.

* * *

This unexpected diversion from the scenario seems to have ended. Stockman's romance with Kaufman et al is done with, ending in disillusionment. Who is to say it wasn't necessary, to clear that static model out of the way for everyone. The time wasn't wasted either. The White pieces meanwhile captured Donald Regan from the ranks of the Wall Street business and bank economists, and it was Regan who cued the President into publicly disparaging "Wall Street" for its criticisms of the tax program. It is now Treasury and Regan arranging the tax program that will finally realize the expectations of the last several months.

The delaying process has also been expensive for the Democrats, for they have been identified in the public mind as the chief cause of the delay, and the public-opinion polls for the first time in a half century are beginning to identify the GOP as the majority party. In rejecting the tax "compromise" that the Reagan administration tendered in late May, the Democratic liberals in effect decided to join hands and go down in flames, kamikaze-style, a la the GOP's 1964 kamikaze trip with Barry Goldwater.

All that remains is for the President to get a vote on the House floor for a tax bill that he says he wants and must have and he will have it. The likelihood that House Democrats en masse would rise up against a Reagan tax cut, when it came time to vote, has always seemed ridiculous to me. The theological leaders of the liberal camp can claim that their ranks are solid, and the White House might believe them, and negotiate accordingly. But if the compromise the liberals rejected were voted upon in the House, the ranks would break and it would pass with 400 votes.

Such a bill would cut personal rates by 25 percent - 5 percent on October 1, 1981, 10 percent on July 1, 1982 and 10 percent on July 1, 1982. It would reduce the 70 percent rate on interest and dividend income to 50 percent on January 1, 1982. It would increase the exclusion on gift and estate taxes to $600,000 from $150,000. It would accelerate depreciation on a 15-5-3 schedule. It would reduce the so-called "marriage-tax penalty" and increase the deferred income allowances under IRA and Keough plans. And there's room left to increase the exclusion on capital gains to 70 percent.

A member of Congress who could vote against this package would have to be willing to shoot Santa Claus. Sure, it's a Christmas tree with a present for everyone. But it would have a powerful effect on the economy, with expanded incentives that would invite consenting adults from coast to coast to commit commerce.

The chances that such a bill will pass this year are extremely good, so good that only gross error on the President's part can deny it. Indeed, now that the liberals have bowed out, the White House should escalate its proposal instead of trimming it; Rep. Jack Kemp recommends cutting back the top marginal rate to 46 percent, in line with the corporate tax rate.

In the bull-market scenario, this means that we are finally on the threshold of major advances in the DJI and the broader indices as well. The market can discount probabilities only so long before it must be fed reality, and these milestones are now at hand. A DJI of 1200-to-1400 by year end would be reasonable.

Another key element of my July 1978 scenario was a convertible dollar, and that too is a milestone we can begin to see on the horizon. At least, it is no longer grounds for general snickering when the subject is raised in informed circles.

There is a non-aggression pact between the White House and the Fed these days, which will last only as long as the status of the tax bill remains unresolved. Older and wiser from his dalliance with Kaufman and Greenspan, David Stockman is back in a supply-side groove on monetary policy. The White House high command generally has come to understand that you cannot have a supply-side fiscal policy and a demand-side monetary policy. As long as the Fed thinks it is fighting inflation by denying legitimate demands for credit, as transactors strain to produce and exchange in this new supply-side world, the full benefits of the tax reforms cannot be realized. Now that Treasury Secretary Regan has appointed Lewis Lehrman to the Gold Policy Commission, and Lehrman is back in frequent consultation with the power centers in the administration, monetary reform is all but officially on the agenda.

In the 1978 scenario, the DJI move to 3000 is accompanied by tax cuts down to a top of 25 percent, regulatory reform and a hard, convertible dollar. To that list now would have to be added repeal of those bearish drags on the economy that Jimmy Carter added in the interim, the windfall profits tax and the extension of controls on natural gas. A DJI of 4000 required extension of fiscal and monetary reforms to the rest of the world, another idea that seemed ridiculous three years ago but now is ripening. Whatever the day-to-day developments, though, it remains my belief that all setbacks in this bull market are only temporary, and that it will extend into the next century. Wait and see.

1 Jude Wanniski, "A Bull Market Scenario," H.C. Wainwright & Co., Economics, Special Report, July 26, 1978.