Few Choices Beyond Stocks

If he were asked to advise the President, William Wolman -- author and longtime BusinessWeek economist -- says he would recommend rescinding much of the recent tax cut as soon as possible. Wolman's argument is that the federal government is trying to feed three "voracious" mouths: military spending, social services (notably changes in Medicare), and its own drive to cut taxes ("especially for the rich," he notes). At the same time state and local governments are raising taxes to cover their deficits and thus causing some inflation -- which is, incidentally, why Wolman doesn't see deflation in the country's future.

These were some of the points Wolman made in an investing chat presented July 8 by BusinessWeek Online and Standard & Poor's, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Bill, you've been talking about a flat market, but right now it seems to be anything but flat. What's your broad outlook?

A: Well, it's certainly true that the size of the market's rise has been beyond my expectations -- luckily for those who have had a bullish attitude. However, I remain somewhat skeptical. It's apparent that the slug of fiscal stimulus that is embodied in the Bush tax cuts, particularly the cut in the tax on dividends, has led to considerable enthusiasm, which is reflected in the market.

It's also true that the extremely low rates of return on bonds have forced institutions, and particularly corporate pension funds, to take a more aggressive attitude toward stocks. However, I still think that there is a problem with economic growth, and it appears to me that at least for the past month, the market has been running well beyond what can reasonably be expected (see BW Online, 7/11/03, "Crunch Time for Wall Street").

Q: With the stock market at very high levels, bonds and housing at high levels, where should one invest for one to three years?

A: It seems to me that the essential problem of the economy is that the great housing refinancing boom, which has provided liquidity to huge numbers of American households, simply can't go on at the pace of the past couple of years.... While I'm hardly suggesting an immediate bursting of the housing bubble, I'm suggesting that liquidity generated in this market will begin to decline.

I simply don't see great strength in the consumer sector. So while the tax cuts will do some good as the checks start getting mailed out, I wouldn't get too excited about it. Under these circumstances, I would really recommend that people don't play the investment game in the housing market, as they have been over the past few years.

I also think that it's the wrong time to buy long-term government bonds, since I do believe that there will be a slight upward tilt to interest rates. That, of course, leaves the stock market, and that frankly is why I think stocks have been going up over the past couple of months. That rise in the market could last for a while. But the profits growth will simply not be there.

Accordingly, although it doesn't sound very good today, I still think that people should keep a good deal of their resources in the equivalent of their mattresses, staying with short-term governments. I am, as you also know, a great fan of the government's TIPS [the inflation protected bonds that are paying over 4%, with no risk of capital loss].

Q: What do you see as the fastest-growing sector this quarter?

A: That is a good question. My guess would be health care, which is hardly very imaginative, but I don't see much else that will grow relatively rapidly.

Q: Are we really in danger of deflation?

A: I believe that I was one of the first economists to raise the deflation issue, which I did about three years ago. As it turned out, while we didn't get deflation, we certainly got disinflation. Now, that deflation argument has become fashionable, and that, of course, means that it's probably wrong.

My own guess is that the inflation rate will increase somewhat, as it already has -- catastrophically for those paying education bills -- so as to actually hold back the rate of real economic growth over the next 12 months, and perhaps longer. So my basic outlook is for a little bit more inflation than most economists expect, just as three years ago it was for a little less inflation than economists expected. This is not a bright scenario for the stock market.

Two other points...my property taxes are going to rise this year because of rising education costs and other pressures on state and local governments. Property taxes, at least in the area where I own property, are a major source of inflation in the squeeze they put on my disposable income. Also, states have been raising sales taxes, and not just in New York, where the rises have really been unbelievable. Call that government inflation.

Q: Do you see any hope at all for the devastated telecom sector?

A: That is an excellent question, and I'm no expert in the area, but I believe that with the rapid growth of wireless, a lot of the money that was spent in laying cable and in other ways will result in what is in effect capital equipment that will never be used. Under these circumstances, I think this is a very difficult area for investors and is likely to stay that way.

Q: What could our President do to help our economy? Bill, imagine that you're chair of the Council of Economic Advisers!

A: The answer is, not much at this point. The truth is that the U.S. is faced with three contending goals in what its objectives must be, all of which are voracious. One is obviously the cost of the military and the size of our very expensive Army, which would cost huge amounts to expand.... The second is obviously the need for social services, which is now being reflected especially in the talk about reforming Medicare and providing prescription-drug benefits. And the third is the ideological drive of the Bush Administration to cut taxes -- especially, if I can be excused for saying so, for the rich.

I don't have much hope that the Administration will face up to these problems in a truly satisfactory way, and I'm therefore somewhat worried about the longer-term future. If I were President Bush's economic adviser, I would do what his father did and what even Ronald Reagan did, which is to rescind a good part of the tax cut as soon as possible.

Q: The NASDAQ is climbing faster than the Dow -- what is it telling us about tech stocks and their valuations?

A: Perspective is required. The NASDAQ is still 60% below the peak that it reached in the spring of 2001. So while the recovery is spectacular, there are still deep wounds in the kind of NASDAQ-based portfolios that people had at that time.... I'm still a believer in tech, and I haven't mentioned that I think that the biotech revolution will make the information revolution look like child's play before it's all over. The successes will be spectacular.

Q: So, in sum, Bill, this is not a time for too much optimism -- but also on balance not a time for the storm cellars. Your final advice would be?

A: My final advice would be for people to recognize that your summary of my view is excellent, Jack, and I have nothing to add to it.

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