Prepared by The Wall Street Digest, Inc.

Economic reports continue to show slow but strong economic growth, declining inflation, and rising productivity. This is a perfect scenario for rising corporate profits and higher stock prices ahead. The Fed is doing its part to maintain adequate liquidity in the economy. The Fed adds liquidity to the economy almost daily. The broad M3 money supply is growing rapidly, and total liquidity in the U.S. is over $4 trillion, a record and still climbing.

There is approximately $2.1 trillion in equity mutual funds. The total value of the stock market is just over $9.1 trillion. The broader stock market is still in a healthy uptrend.

The advance/decline line is still rising. That means there are more stocks rising in price than are falling. The new highs/new lows indicator is very healthy, showing less than 20 new lows during each day of trading on the NYSE. The NASDAQ is rising to new highs almost every day, while the Dow 30 Industrial stocks have been in a trading range between 7600-8000 since reaching a new high of 8259 on August 6.

We forecasted this scenario in our August issue and recommended that you concentrate on the small cap stocks and mutual funds. Those who did, have impressive profits today.

The media has been comparing the 1997 rise of the stock market to 1987 and to the Japanese stock market collapse in 1989. The charts they create visibly imply that a crash of the U.S. stock market is ahead. We emphatically disagree. The Fed had raised interest rates relentlessly during 1987 to bring inflation under control by slowing an overheated economy. Monetary policy was very tight in 1987.

The Japan central bank was also raising interest rates and had also shifted to a very tight monetary policy in 1989. That is not the case today.

The Fed is not raising interest rates and monetary policy is accommodative to economic growth and higher stock prices. The previously mentioned charts show this very clearly. The stock market is overvalued, but that condition can exist for months before one of three things happens to correct valuation levels: 1) Earnings rise, reducing P/E ratios, 2) Stock prices fall, or 3) Stock prices stay in a trading range while earnings rise.

We believe the latter scenario is unfolding now with the Dow 30 Industrial stocks. The small cap stocks have acceptable valuation levels and should continue to rise in price well into 1998.

A slightly higher U.S. Dollar will mean that U.S. exports are slightly more expensive. That will not help the big cap, international stocks. However, a slightly higher U.S. Dollar means cheaper imports will keep inflation under control. Fed bashing is popular today, but not very appropriate. The U.S. economy today is more powerful and far healthier than ever before.

A strong, stable dollar, low U.S. interest rates, low inflation, healthy economic growth, rising productivity, and an enormous lead in information/computer technology have all made the U.S. the only military and economic superpower on the globe. Japan, Germany, and China all have serious structural and government regulation problems that are not being addressed nor even recognized.

As a result, money continues to pour into the U.S. from other less fortunate countries at the rate of $80 billion per quarter, $320 billion annually.

A good portion of this foreign money flows into our stock and bond markets. The forces of deflation on our economy are not generally recognized. Between 1865 and 1900 prices in the U.S. fell 30% because of rapid technology advancements. The deflation was controlled. However, prices fell an average of 1% per year for 30 years, while the economy enjoyed robust economic growth and expansion.

We believe the U.S. economy will experience faster-than-expected growth with very low inflation over the next decade. Corporate profits will continue to grow pushing the Dow Industrial Average to 18,000 by the year 2008.

Everybody loves disinflation. It, after all, produced the great 15-year bull market. Deflation, however, is something else. It destroys profits, reduces incomes and government revenues and can set off a self-reinforcing cycle. Buyers wait for lower prices, producers cut them to generate sales, suspicions are confirmed, etc.

That's why in the 1930's FDR's New Deal set up an operation called the NRA (National Recovery Administration), whose principal job was to try to stop falling prices and wages.

It couldn't happen again? Don't be too sure. U.S. producer prices have fallen for six months straight. I believe that there is a much greater danger today of falling prices than of renewed serious inflation. Why? With the end of the Cold War, highly inflationary defense spending is unwinding.

Virtually all governments are hell-bent on shrinking spending and deficits. There's nothing like eliminating government stimulus to promote deflation. Meanwhile, central banks are still vigorously fighting the last war, inflation. That in itself has a deflationary influence. Also deflationary is the restructuring that started in the U.S. and the U.K in the early 1980s.

It has spread to other English-speaking lands and is beginning to reach the Continent and Japan. Information technology has deflation written all over it. Global sourcing is hugely deflationary.

Emerging economies compete with each other and force down prices as they over-expand production facilities. Watch what's happening in Asia, especially China with only 50% of her manufacturing capacity utilized. That may be the cradle of modern deflation. Continuing dollar strength is distinctly deflationary for the U.S.: it stalls exports and forces down the prices of competing domestic goods and services.

Most developed and emerging countries are now competitively devaluing against the dollar. Like the 1930's, but with Washington's willing cooperation.

What could trigger disinflation's turning into deflation? The U.S. consumer cutting back on visits to the mall. Final demand would drop just as production was ramping up. For two decades the consumer has spent as if every day were Christmas, but just wait until the Fed jolts the economy and the stock market with the next interest rate rise–as it surely will, given its obsession with inflation.

Deflation isn't bad for everyone. It is pleasant for those owning long-term bonds or living on fixed incomes. Deflation is rough on borrowers, especially junk-bond borrowers.

Farmers would suffer under the impact of lower crop prices and fixed costs. Producers of commodity products would find their operating leverage working against them, and many would be selling goods at a loss. The current real estate boom would turn into a rout. I don't think I would want to be in the car business when prices started dropping.

But deflation doesn't necessarily mean depression; the 1930's were something of a special case, but the 1920's and post- Civil War deflationary eras were boom times.

Some companies will benefit because they can maintain prices while their costs will decline. Strong, really strong, brand names will be able to maintain premium prices. The Wrigley chewing gum company made out nicely in the 1930's. High-technology industries that already know deflation well will continue to thrive as the demand for cost- cutting equipment becomes even more intense.

Bonds, of course, will be strong. Deflation unthinkable? It's when people least expect these things that they strike. (A. Gary Shilling, Forbes magazine, August 25,1997)

(WSD Editor's Comment: Economist Gary Shilling is not alone in warning about the possibility of deflation. Edward Yardeni, chief economist at Deutsche Morgan Grenfell, warns that deflation is a bigger problem than inflation in the article that follows.)

In July we recommended six Japan mutual funds to you because of the Japanese government's efforts to stimulate faster economic growth. Almost simultaneously, the Chinese government began an aggressive campaign to capture market share from virtually every country in Southeast Asia.

The two cheapest places to manufacture anything at the time were China and Vietnam with a monthly wage rate of $68 U.S. per month.

With a currency advantage over other Asian countries and price cutting to aggressively capture a greater share of the manufacturing business, China has adversely affected every economy in Southeast Asia except Hong Kong. Stock prices in Japan are off approximately 9% since July, mainly because of China's newly aggressive stance to capture more business.

Why is China so aggressive? Unemployed Chinese workers in virtually every large city picket the government every weekend. This is unusual. Even more unusual is the government's response.

They have not moved against the picket lines. Instead they are moving quickly to create every possible new job. China may or may not silence the unhappy Chinese workers, but the economy of every nation in Southeast Asia, including Japan, will probably suffer. Some Asian analysts are saying this is just a bump in the road and view the current pullback as a buying opportunity.

Other respected analysts say this could be the beginning of an implosion of the Chinese economy. Why?

The Communist leaders have no concept of the business breakeven point and no respect for the right of every business to make a profit. The Capitalist view is that every business has a responsibility to make a profit and protect the financial strength of the company, so that it will be able to pay its workers a timely, fair wage.

Unfortunately, China's leaders have no appreciation for these basic business concepts. China still has almost one thousand state owned businesses that have not made a profit in years.

Nor can the government shut down these companies because it would dramatically increase the number of unemployed workers. In the past, China feared the students would overthrow the Communist Government. Now they have an additional fear: angry, unemployed workers.

We are, therefore, recommending that you sell all positions in Japan mutual funds and use any pullback in September and October to increase your allocation to the U.S. stock market to 70%. Our portfolio allocation is as follows:

70%.....................................U.S. Stock Market,
20%...........................30-Year U.S. Treasury Bonds,
................................30-Year Zero Coupon Bonds,
 10%.........................................Latin America
100%

“Markets are never wrong; opinions are,” is a quote from Jesse L. Livermore, one of the most colorful, flamboyant, and respected market speculators of all time. We agree wholeheartedly with his comment. We truly embrace this thinking in all of our work. Human nature is no different today than it was back in the 20's and the 30's when Jesse Livermore was a major force on Wall Street.

Certainly the regulations controlling market activity have changed greatly. But the psychology of the marketplace is unchanged. Investors have the same hopes and fears today that they had seventy or eighty years ago.

Mr. Livermore saw repeatedly that the opinions of many of his colleagues were frequently wrong, as the market went on its own merry way in a direction contrary to what they had expected. Market opinions are no more accurate today. For many months you have heard bearish statements similar to these, “This aging bull market is soon coming to an end. It's way overdue for a major tumble.”

And, “This market is highly reminiscent of the 1987 market, just before the big crash!” And lastly, “The price-earnings ratios of today's stocks are higher than they have ever been, and it's about time this market came back to earth.”

In fact, the cover of this week's Barron's showed a timer going tick, tick, tick, and a caption, “After six years of prosperity, how much longer can the good times last?” And let's not forget Federal Reserve Chairman Alan Greenspan, who last December, with the Dow 1200 points lower, spoke of the market's “irrational exuberance.”

If Jesse Livermore were here today, reading bearish comments such as those above, he would probably say, “Rubbish! It never pays to predict market direction. You should be listening to this strong bull market and doing what it's telling you to do...be fully invested.” We can't remember a time when our indicators were more bullish than they are now. All four of our market indicators are solidly bullish. We are particularly impressed with the latest readings of the advance- decline line of the NYSE.

It broke out to a new record high on September 8, while the Dow Industrials were still mired more than 400 points below their peak of August 6.

Since the action of the A-D line usually precedes the action of the Dow, the A-D line is telling us, loud and clear, that the Dow is going to start to develop more strength and move ahead to new highs in the weeks ahead. Look also at the two-second indicator, which measures the daily new lows on the NYSE. Low, low readings. Clearly bullish!

Also there is good news in the Dow Utility Average, which just hit a new six-month high. This is an excellent indication that interest rates are remaining under control.

There just aren't any selling pressures on the market. And why should there be? Where would you put the money if you took it out of the stock market? There isn't a better place for your money at the present time. That's why money continues to flow into the stock market at such a high rate. We continue to be in a bull market of unknown duration. We're keeping our eyes and ears open for possible changes in this market.

But as of the moment, we don't see anything that looks like trouble. Remain bullish and fully invested. (The Cabot Market Letter).

Several months ago Alan Greenspan flew non-stop to Japan and without resting or getting used to the local time went immediately to a meeting of important bankers and government officials in Tokyo. (1 a.m. New York time.) He told them in plain and simple language that if they messed up their economy any worse than it already was and began selling U.S. T-bonds to raise money, he would stand there with a basket and an open check book, to buy bonds.

But he would not lift one finger to bail them out. They would have to solve their own problems, he said, even if that means printing money in sufficient quantity to cause some inflation.

Greenspan flew to Germany to deliver the same message to European bankers and government officials. Our instinctive read of what is going on behind the scenes is that Greenspan may already have opened the Fed's bottomless “magic” checkbook and has started to buy up billions of dollars worth of T-bonds being dumped by desperate Central Banks in Asia, Europe and maybe Latin America.

We believe that the Treasury has anticipated and planned for just this eventuality.

That is the only reason we can accept to explain why inflation-indexed Treasury savings bonds have been introduced at a time when no one thinks there is inflation, and why the new budget agreement allows Americans for the first time to include foreign-produced gold and silver bullion in their IRA accounts, whether in the form of coins or bars.

Once Greenspan pays foreign Central Banks for American bonds they want to sell, the U.S. Dollars he creates will be spent in the nations that are involved.

A percentage of these new dollars will find their way into the hands of rich, sensitive and alert private investors and corporations. They will quietly route as many of these dollars as their own nation's currency controls allow back to the United States. There these dollars will join up with the tidal wave of money that has been washing up onto our shores (or coming into being through stock market profits).

This money, when combined with the wealth that is already here and that we believe will be created in the next few years, should be sufficient to finish the process of creating here in North America an impregnable fortress of commercial and industrial prosperity.

We have scoffed at the notion that China will replace America within 20 years as the most powerful nation in the world. (Instead we foresee a collapse of historic proportions in China, as the rigid communist regime inadvertently destroys the semicapitalist boom lately raging along its coast. For 15 years, since 1982, we have been telling you that the America emerging from its own five-century base-history was about to take its place among the supreme civilizations of all recorded history.

Greece, Rome and Great Britain all had their Golden Ages...but in our view each of them and indeed all of them together cannot and will not match the wealth, power and cultural influence of the America that will now dominate the world.

But, having dismissed talk of a new deep recession in America, we have to be completely candid and admit to you that we are not at all sure the U.S. can so easily stave off problems running in a positive direction. By that we mean the undeniable fact that too much of a good thing can turn itself inside-out, switching its sign from positive to negative so to speak. This is something that Wall Street has already begun to suspect and worry about.

We cannot rule out periodic bouts of inflation, as large sums of money continue to pump up the U.S. economy. (The FRC Money-Forecast Letter).

Deflation may not appear to be much of a risk here in the U.S. and in Europe. Ten-year government bond yields are trading around 6% in both the U.S. and Germany. But in Japan, the yield just fell below 2%, the lowest on record. In my Topical Study #32, “The Undefeated Forces of Deflation,” dated October 28, 1996, I argued that the central bankers of the major industrial economies would have to keep interest rates low for a long time to offset the natural forces of deflation that recur after wars.

The unweighted average of short-term interest rates was only 4% in August, well below the 10% average in 1990, the year that marked the end of the Cold War.

In my Topical Study #32, I argued that there are at least six sources of deflation: 1) The influence of falling prices in the high-tech sector on other industries, 2) Cheap products from China, 3) More global capacity financed by “easy equity money,” 4) The bursting of speculative bubbles in stock markets around the world, 5) Tight fiscal policies required for European monetary unification, and 6) The failure of Japan's economic recovery.

Reflationists, of course, dismiss the deflation risk. They've been predicting a series of rate hikes in the U.S., Germany, and Japan for well over a year. They did get a 25-basis-point hike out of the Fed in March, but nothing more since then.

The Germans are expected to raise their rates to defend the weakening Deutschemark. Such a misguided move would worsen the forces of deflation in Germany, which have pushed the jobless rate to a new, post-WWII record high of 11.5% in July. (Deutsche Morgan Grenfell Weekly Economic Analysis).

September 1997The Wall Street Digest, Inc.

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