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The Prosperity Boom

By Lawrence Kudlow

The U.S. stock markets were looking for a correction for some time now and on Tuesday they found it: a 3.5% sell-off across the board. The plunge follows a 20% run-up that began last summer, and some analysts believe it was overdue. Indeed, 3% corrections are normal and healthy. Legendary financier J.P. Morgan knew this a hundred years ago when he told a congressional panel that prices fluctuate. But the trigger for Tuesday's drop undoubtedly came from China.

The Chinese have sent a Shanghai flu across the globe. There is talk in China's government circles of slowing its boom and the "speculative" stock rise that has taken place over the past 18 months. Higher reserve requirements for banks, tighter interest rates, stricter implementation of a capital-gains land tax, and perhaps some form of capital controls are all in the rumor mill. This sounds like root-canal advice from the U.S. Treasury and the IMF, which somehow are dissatisfied with 10% growth and 2% inflation in China. France, Germany, Japan or Latin America should have it so bad.

At home in the U.S., there are still housing-slump worries and concerns about an inventory correction in autos and factories. Former Federal Reserve Chairman Alan Greenspan this week even predicted a recession, naming the budget deficit as the cause. Huh? The deficit is evaporating as record tax revenues are being generated by a solid economy, itself a function of the low marginal tax rates put in place by President Bush.

Current Fed Chairman Ben Bernanke is looking for a soft economic landing, and I agree.

[Bull and Bear]A quick tour of the data: Consumer incomes keep rising amidst low unemployment and record job creation. Ditto for business profits -- the mother's milk of the economy and rising stocks. Exports are strong. An inventory correction, which helped knock fourth-quarter GDP down to 2.2% from 3.5%, will pass. As yet there is no evidence that a sub-prime mortgage lending problem is spreading. There is no economy-wide credit crunch. And bond rates are a low 4.5%, adding more value to stocks. The prosperity boom is alive and well.

In fact, using a modest 8% growth estimate for 2007 earnings, and capitalizing that profits forecast with a 4.5% bond yield, shares appear to be anywhere from 15% to 25% undervalued today. Put another way, the 6.7% forward earnings yield of the S&P 500 compares very favorably to a 4.5% Treasury bond or a 5.7% A-rated corporate bond.

The high-tech, productivity-driven U.S. economy is more durable and flexible than its liberal-left critics will ever admit. It is a private-sector free-enterprise economy, not a government-planned one. Innovation is strong and entrepreneurial spirits are high. The four prosperity killers, a paradigm coined by Arthur Laffer many years ago, all look dormant: inflation, taxes and regulatory burdens are low, while free trade keeps expanding.

One of the most underrated aspects of this bull-market economy is the sharp drop in marginal tax rates on capital formation. After the levies on capital gains and dividends were reduced to a scant 15% in 2003, the supply of easy capital surged, holding down real interest rates and expanding internally generated liquidity. This, plus record profits, has been the major source of the new-liquidity generation that has fueled stock markets at home and abroad.

This is good noninflationary liquidity. It is not bad liquidity, such as occurred in the 1970s when the Federal Reserve and other central banks gunned the printing presses and created the excess money expansion that drove inflation and interest rates sky-high.

Although gold prices are a concern today, the bigger bond market is sending a noninflationary signal. Future inflation spreads are predicting price-level increases of only 2%. The Fed is targeting inflation even more than unemployment. The core consumer deflator increased only 1.9% at an annual rate in last year's fourth quarter, while year-on-year inflation is a low 2.2%. We must keep an eye on gold -- which has a long history as an inflation barometer -- but right now the bond message seems closer to the truth. Additionally, consumer survey expectations of future inflation have come down markedly.

As for stocks, we're back to the stalwart supply-side adage: tax something less, get more of it. The low tax cost of capital has helped create a boom in private-equity buyouts and share buybacks, which pay out to investors in cash, thus adding to abundant liquidity that recycles into higher prices for a shrinking supply of stocks.

All that said, there are threats to growth. For starters there is the union attack on business, where "card checks" would substitute for secret ballots. Jack Welch, the former CEO of General Electric, thinks the unions are aiming at Silicon Valley -- America's most innovative high-tech area -- in a misbegotten attempt to turn the clock back to the 1960s and 1970s when competitiveness and entrepreneurship were at a low ebb. Tax threats associated with fixing the alternative minimum tax also are problematic. But the president has pledged to use his veto pen to prevent higher tax rates and will, according to the vice president, veto any card-check legislation (a.k.a. the misnamed Employee Free Choice Act).

Overall, Washington politics have taken a decidedly anti-growth turn ever since the new Democratic Congress went into session. Carbon caps and protectionist trade threats are the new battle cries. But the leftward moves of the Democrats on both the war and the economy may doom them in 2008. Neither statism nor galloping McGovernism is a prescription for taking the White House, especially with investor-class stockowners casting two out of every three votes in recent elections.

This is why I continue to believe that the prosperity boom is not over, either in the U.S. or around the globe. The spread of free-market capitalism, and its record wealth creation for both the rich and the unrich, is unstoppable. Liberal seers have been predicting the downfall of U.S. stocks and the economy several times a year since the Bush boom began back in 2003. Yet at comparable points in the business cycle, wages and wealth have outperformed during the current expansion.

My advice to investors is to remain optimistic and stay in stocks for the long term, since economic freedom is the tried and true path to growth and prosperity. Isaiah Berlin wrote many years ago that hedgehogs always win the long-term race against foxes. Message to the investor class: Hold that thought.

Lawrence Kudlow is a former Reagan economic advisor, a syndicated columnist, and the host of CNBC's Kudlow & Company. Visit his blog, Kudlow's Money Politics.

This first appeared in the Wall Street Journal. Copyright © Dow Jones & Company, Inc. All Rights Reserved.

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