The Business of America is Business

Larry Kudlow
Thursday, September 02, 2010

Profits up, rates down, tax cuts, and a stock rally.

Corporate profits are at all-time highs and bond rates in the Treasury market are virtually at record lows. That’s a good combination for stocks, and it helped trigger a 255 point rally in Wednesday’s trading. What’s more, a surprisingly positive read on the ISM August manufacturing report delivered a strong blow to the double-dip recession pessimism that has plagued investors for many months.

Without question, the jobs picture is going to remain cloudy. There’s just too much uncertainty over the economy and the tax-and-regulatory threats coming out of Washington. Businesses can’t be sure about the costs of hiring. Meanwhile, over in housing -- our other weakest sector -- an inventory glut threatens further price declines.

But make no mistake about this: Businesses, at least the publically owned ones, are in very good shape. U.S. firms scored a record $1.2 trillion in profits during the second quarter and are sitting on roughly $2 trillion in cash. Our private-sector companies are resilient, and they have recovered significantly from the economic plunge.

And while their hiring is still behind schedule, they have begun the process of investing in equipment, software, and other capital goods. Business investment in the June quarter rose 16 percent above year-ago levels. This is all to the good. Healthy businesses are crucial to the stock market as well as the overall economic outlook.

In fact, since 2001, business profits have doubled, even while the stock market dial has hardly moved. If Washington can just keep its paws off of business and let market processes work, firms will continue to prosper domestically and internationally and will eventually pick up their hiring.

I hate to sound too much like Calvin Coolidge, who after Reagan is my favorite 20th century president, but the business of America is business.

Yes, when second-quarter GDP came out last week, the revised 1.6 percent growth number was universally derided as a step on the road to a new recession. But not so fast.

In a blog titled “What Everyone Missed in the Revised GDP Data,” brilliant Washington economist Alan Reynolds noted that real gross domestic purchases, which are purchases by U.S. residents of goods and services wherever produced, actually increased 4.9 percent annually -- a full percentage-point stronger than the first-quarter results. Reynolds blamed a government accounting miscue over falling import prices for a misread on the trade deficit that subtracted about 4 percentage points from GDP.

So import prices actually increased in the second quarter, which lends credence to the idea that the economy is doing better than folks think. And by the way, the bulk of those imports are being used for capital-goods investment, which is a good thing, not a bad one.

Smoothing out the quarterly ups and downs, the real economy is growing about 3 percent year-on-year, with the domestic economy rising by 3.7 percent. This is a tribute to the resilient and durable free-market system in America.

It’s a pity that Team Obama and the Democratic Congress had to waste nearly $1 trillion on ineffectual spending stimulus, temporary tax rebates, cash for clunkers, and temporary homeowner tax credits -- all of which have probably slowed recovery and prevented equilibrium in key sectors. And that’s not to speak of our huge and burdensome future debt.

Which brings me to the regime change coming in the midterm elections. That’s another bullish factor. As we speed toward November, the Republican party looks set to publish an agenda of limited spending, regulatory restraint, and low taxes, while momentum is gathering to at least temporarily extend the Bush tax cuts of 2003.

And lo and behold, President Obama and his economic team apparently are talking about additional tax cuts of one kind or another. I’m not holding my breath. They are likely to go for temporary and targeted tax relief, the most ineffectual kind there is. They should go Reagan, by reducing marginal tax rates across-the-board for personal, business, and investor incomes. That’s what they ought to do -- strengthen incentives to reignite risk-taking. But the Republican tide is rolling in so strong right now, we just might see Democrats turn to lower taxes.

All this is good for stocks. Using conservative earnings estimates, the S&P 500 looks to be valued at a historically low 11.5 times earnings. That comes to an 8.7 percent yield on shares, compared with only a 2.5 percent rate on 10-year Treasuries.

In other words, profits up, rates down, tax cuts may be coming. In the new political environment, year-end tax-selling by investors may no longer be necessary in 2010 to beat the Obama IRS in 2011.

Let’s have a little optimism for change.