Did Steve Moore Spark Tuesday's Stock Recovery?

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We are skeptical about conventional press accounts suggesting yesterday's stock rally from pre-market lows was primarily fueled by the Federal Reserve's surprise 75 basis point cut in the funds rate. Instead, it appears that rumors of an executive order by President Bush to index capital gains for inflation was a more important factor.

Based on the chart of the S&P futures yesterday, the S&P rallied from the 1260 level to nearly the 1300 level on the rate cut announcement; but within less than an hour, it retreated to 1265 -- almost the pre-announcement level. S&P futures really began to rise around the market open. At that time, approximately 9:25 AM, the Wall Street Journal's Political Diary hit e-mail inboxes. In the morning note, Steve Moore reported that the White House was seriously considering inflation indexation of capital gains. As this news spread throughout the day, stocks worked their way higher.

Certainly reduced capital costs sparked by the Fed funds cut is a positive development at the margin. But in a credit market where spreads between low risk Treasuries and corporate bonds are widening as a result of an increased reluctance to assume risk, the beneficial effect of the Fed lowering the Treasury curve via funds rate reductions may be somewhat diluted. This may explain why stock futures barely changed on net within one hour of the rate cut announcement, but also lends credence to the argument that another, highly positive variable was at work -- around the market open.

Certainly indexing capital gains for inflation would effect a positive change in the tax code, and would increase incentives to take investment risks. This is especially true with gold at $880/oz., compared to an approximately 12.5 year moving average of around $400. The former price is forecasting a 100 percent increase in the broad price level over the next 10 to 15 years.

Taking this further, if we Ignore the inaccuracies associated with the CPI or other statistical price measures, were the S&P 500 (with a current market capitalization of $11+ trillion) to double during the above timeframe, any executive order today to index these gains for inflation would mean that the future $11 trillion appreciation in the S&P would be tax free after inflation adjustments. In short, inflation indexing would constitute one of the largest tax cuts we've ever seen in dollar terms.

The "indexation news explanation" for yesterday's rally has significant implications for today's market action. There is no mention in this morning's major news outlets that discussions between President Bush, Majority Leader Reid and Speaker Pelosi included indexation. Even the Wall Street Journal's page A3 summary today by Hitt and Lueck fails to mention it. Has the idea been scrapped? Given the enormity and importance of the proposal, and the effect the rumor of its consideration may have had on stocks yesterday, this question itself threatens stocks today, and forecasts greater stock volatility ahead as news about Washington's fiscal stimulus plan - for better or worse - solidifies.

Paul Hoffmeister is chief economist for Bretton Woods Research. He can be reached at phoffmeister@brettonwoodsresearch.com.

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