Investors are starting to look past Iraq. When they do, they see some things that alarm them. Hence the choppy markets--up smartly for a few days, then down again. A real rally that will take us from 8,000 back to 10,000 will require solid evidence that the Fed will provide enough liquidity to get the economy growing--and it needs to be convinced that Congress is going to pass the dividend tax cut.
The New York Times and its allies have mounted a massive attack on the stimulus package. Their strategy is to create the impression that the tax cuts are "voodoo" economics. This influential newspaper recently "reported" that the tax cut is a gamble resting on "notions that remain highly disputed among economists."
All this convinced many investors that the pro-growth tax cuts won't be forthcoming. The Administration's disorganized defense isn't helping.
But that newspaper and its Democratic pals are wrong. Federal deficits do not cause inflation and do not raise interest rates. The Fed can run a $248 billion deficit next year without putting any upward pressure on interest rates.
Bear with me while I explain why. The outcome of this debate will determine the direction of the market this year.
The first thing to remember is that Treasury securities are assets, so, as the federal debt grows, so does the amount of assets people own. People own all sorts of assets, including government debt. According to the most recent Federal Reserve Flow of Funds Accounts, Americans--not counting the government--hold assets worth about $123 trillion. Of that, $32.3 trillion is tangible assets, like houses and cars, and the remaining $90 trillion is financial assets, including bank accounts, equities and bonds. Those assets grow at about 7% a year--$8.6 trillion. So, at $3.5 trillion, the federal debt looks pretty puny by comparison. Even a $250 billion federal deficit would require investors to increase their holdings of Treasury securities by only 0.2% of total assets. Don't tell me that interest rates would have to soar to persuade investors to hold this extra smidgeon of highly prized government bonds.
The real action in asset markets happens when investors change the way they allocate their assets. That's why it is so difficult to see the effect of deficits on interest rates--they are blown away by the tidal waves created when investors change their asset preferences. That's also why the dividend tax cut is bullish for us stock market investors--it will encourage people to move to stocks at the expense of real estate and bonds. Up goes the stock market.
So don't be distracted by nattering about temporary deficits. Remember that the late lamented bull market of the 1990s got started when President Reagan's tax cuts were ballooning the deficit. Don't be distracted by deficit scares in media like The New York Times. Take advantage of those dips in the market. Accumulate quality stocks like Citigroup (nyse: C - news - people ), AIG (nyse: AIG - news - people ), GE (nyse: GE - news - people ), Johnson & Johnson ( nyse JNJ) , Pfizer (nyse: PFE - news - people ), Intel (nasdaq: INTC - news - people ) and Microsoft ( nasdaq; MSFT) ; all are sensitive to interest rates.