REVIEW & OUTLOOK (Editorial): The Market Is Back
When the stock market took its mid-January cold shower we ventured the opinion that stocks don't fall for long on good news. And sure enough, a steady recovery capped by last Friday's strong performance has sent the Dow Jones Industrial Average to a new high.</br></br>We assume investors and traders liked the strong December showing of the government's index of leading economic indicators, which seemed to confirm a general mood of optimism among economists. The latest numbers on insured unemployment showed a nice drop. News that sales of new homes rose 7.4% last year to the highest level since 1979 was further evidence that lower interest rates can do some nice things. And the market seems to have gotten over whatever jitters it had about the future trend in interest rates.</br></br>But perhaps even more interesting was the apparent willingness of the market to shrug off what some observers persist in regarding as bad news, the large trade deficit. December's record imbalance, exceeding $17 billion, sent the deficit for all of 1985 up to more than $148 billion, of which the Japanese, unsurprisingly, accounted for more than a third. One explanation of the market's unconcern is that securities traders know that many of those dollars earned by foreigners will be invested in the U.S. capital market.</br></br>Yet another reason the trade deficit failed to scare the markets is no doubt the perception that trade deficits are ultimately self-correcting. When the world begins to get satiated with dollars, the dollar softens, which is, of course, what has been happening since last fall. "J-curve" theorists explain that the initial effect of a softening currency is to widen the trade gap, since imports become more expensive and exports less remunerative. But the longer-term effect is to discourage importing and, all things being equal, make U.S. goods and services cheaper to foreigners.</br></br>This doesn't mean that a chronically soft currency is a good thing over the longer term. It usually implies inflation. But with oil prices falling of their own weight, the Federal Reserve has had a window of opportunity to let the dollar soften without inordinate inflationary risk.