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Stock Cycles

Progress of the secular bear market: position as of August 31, 2008

The value for R is 1620 as of August 2008. For S&P500 of about 1250 this gives P/R of 0.77.

Tax-Cut Economics, Is it Really Pro-Growth?

Republicans often bill their brand of tax cut economics as pro-growth. On the surface it would seem that that lower taxes ought to encourage economic growth. The argument goes something like this. Taxes are like fines, they tend to discourage the activity being taxed. Thus, tax decreases on investment income ought to increase investment. Investment is usually required for business expansion and the new jobs it creates. Hence, tax cuts should stimulate business expansion and job creation and so are good for the economy. It sounds reasonable, but is it true in practice?

Effect of tax cuts on investment

A reason place to start investigating this claim is to examine the idea that tax cuts stimulate investment. Consider taxes on interest income. Interest is the return on debt. Tax cuts on interest income should encourage the creation of more debt and the interest income it generates. Interest income is taxed as ordinary income and since the rich possess most of the lendable funds, the relevant tax rate for interest is the top tax rate on ordinary income. Figure 1 shows a plot of total credit market debt in constant (2000) dollars over time. The data is plotted on a log axis; different slopes mean different percent rates of growth. Shown in red is the top tax rate. Prior to the Reagan tax cut in 1981, debt rose at just over 2% annually, on average. Between 1981 and the early 1990's debt growth rate more than tripled. Tax rates strongly decreased during this time. Simultaneously with the Bush-Clinton tax increases, debt growth slowed to a crawl. After the Bush tax cuts over 2001-3, debt growth has quadrupled. The conclusion is clear, tax cuts increase the rate of debt creation; tax increases decrease the rate.

Figure 1. Trends in credit market debt 1952-present

Tax levels also influence capital gains income. Consider the 1997 capital gains tax cut. When the tax was passed at the end of July 1997, Standard and Poors 500 stock index (S&P500) was about 900. Eight months earlier, Fed Chairman Greenspan had given a warning of excessively high stock market valuations, after which the market had advanced another 20%. The price to earning ratio (a measure of stock valuation) on the S&P500 was above 22, slightly higher than it had been at the top just before the 1987. The stock market was clearly overvalued; there was little likelihood of additional gains in the absence of some new stimulatory factor. The capital gains tax cut apparently provided this stimulation because the already-overvalued market rose another 70% over the next three years. An ordinary bull market was transformed into a bubble.

After the stock bubble collapsed, capital gains taxes were reduced still further in 2003. Stocks were a damaged asset class because of their recent collapse and so housing prices were the chief beneficiaries of this tax cut. A housing bubble developed which at present is still in the process of collapse. It would seem that since real estate peak, a new bubble has emerged in commodities, particularly oil. Two other times in history, capital gains tax rates were reduced to 20% or lower: in the early 1920's and in the early 1980's. Both cuts were followed by stock market bubbles that ended in crashes. So it seems that capital gains tax cuts can stimulate asset prices enough to produce financial bubbles.

Figure 2. S&P500 earnings and dividend growth 1992-present

Figure 2 shows that dividend tax cuts likewise work to stimulate dividends. Shown in red is the annual dividend on the S&P500 over the last two business/investment cycles. The data are plotted on a semi-log scale to show relative growth rates. Dividend growth after the 2003 dividend tax cut was clearly higher than it was in the 1990's. Earnings growth (the ultimate source of dividend growth) was about the same in both decades.

Figure 3. Trends in tax rate and private non-residential investment since 1950

So far I have shown that conservative notions about the effect of taxes on investment are quite valid for interest, dividends, and capital gains income. This kinds of investments are only tangentially related to economic growth and job-creation. A more relevant class of investment is total private non-residential investment. Figure 3 shows a plot of private non-residential investment since 1950 as a percentage of GDP. Also shown are the top individual and corporate tax rates. The period covered is divided into the same periods as was Figure 1.

Figure 3 shows that investment trended up in the 1960's and 1970's, fell during the 1980's, rose in the 1990's and fell again in the 2000's. This pattern is opposite from what one would expect based on the tax cut model for growth. The tax cuts of the 1980's, which produced an explosion in lending (see Figure 1) were accompanied by a decline in nonresidential investment. After the Bush-Clinton tax increases, non-residential investment rose while debt growth slowed. Following the Bush tax cuts, debt levels again began to rise while non-residential investment has fallen.

With this we can conclude that tax cuts on investment income do stimulate some kinds of investment, but not the kind of investment most tied to economic expansion and job growth. In theory, then, tax cuts should not stimulate economic growth and job creation because they do not stimulate the right kind of investment.

Figure 4. Trends in employment and income since 1960

Effect of tax cuts on employment and income growth

Figure 4 examines the trends in the desired outcome from business investment: growth in jobs and incomes. Shown is the product of total employment and real median income, expressed as trillions of constant (2000) dollars. This product is related to total employee income and was chosen to represent two desirables (job creation and income growth) in a single parameter. Data for total employee income exist, but these data include income for management and highly paid workers and thus do not reflect how the nation's "rank and file" citizens are faring.

Growth in this measure of economic performance was strong in the 1950's (3.8%) and 1960's (4.3%). Growth in the next three decades has been slower: 2.0%, 2.1%, and 2.3% in the 1970's, 1980's, and 1990's, respectively. It has been positively abysmal in the 2000's (0.5%). Taxes were very high in the 1950's and 1960's, when growth was excellent, but also in the 1970's when growth was much less. Growth was slightly higher in the low-tax 1980's than in the 1970's, but lower than in the higher-tax 1990's. Growth in the 2000's, the decade with the lowest tax rates of all, has been by far the worst.

Also shown in Figure 4 is median income for men. Strong growth in income was seen until 1973, which was followed by a two decade hiatus. New highs in income were only obtained in the 1990's business cycle. Since 2000 incomes have again declined. The sharp slowdown in the growth of total worker income largely reflected declining wages/salaries after 1973. The large Baby Boom generation entered the work force in the 1970's and 1980's. Absorption of all these unskilled workers likely impacted wage growth. By the 1990's the smaller Generation X were entering the work force, but massive immigration meant that job demands stayed high. Job growth remained very strong in the 1990's and income growth was better than it had been since the pre-1973 era. As described above, total worker income grew more rapidly in the 1990's than during any other business cycle since 1973.

Based on the data in Figure 4, we can say that no evidence exists that tax cuts stimulate growth in jobs and worker incomes. This finding is consistent with the fact that tax cuts do not stimulate private non-residential investment. This result is counter-intuitive. Why should tax cuts on investment not encourage investment that leads to economic growth and job creation?

Factors other than tax rates influence business investment

The reason why post-1980 tax cuts did not stimulate job-creating investment is because tax rates are not the primary determinant of whether or not a business invests in expansion. Tax rates on investment income do not matter all that much to businesses because they tend to use other people's money for their investments, usually through borrowing. In this case, what matters is the cost of money (i.e. the interest on the loan) and not the rate at which their profits will be taxed.

Tax rates do matter to investors who are investing their own money. Lower taxes increase their effective return, making investing more attractive relative to spending. Hence we do see clear effects of relevant tax cuts on debt, dividends, and asset prices (bubbles).

To explore the relation between interest rate and business investment, Figure 5 shows the trend in private non residential investment and the Aaa corporate interest rate over time. Figure 5 clearly shows that likely cause of the 1980's decline in investment was skyrocketing interest rates. Once interest rates fell to more normal levels investment resumed. Rates continued to fall in the face of a steadily growing economy and low inflation in the 1990's. It is not surprising that investment rose strongly in the face of higher taxes. Since 2000 interest rates have been very low while business investment has been lackluster despite tax cuts. Once again the reason seems clear. During this period the economy has had to deal with the aftermath of two collapsing asset bubbles, which have understandably depressed what Keynes called the "animal spirits" of businessmen (their willingness to take on risk).

The reason why interest rates rose in the 1980's is also clear. During the 1970's inflation soared. One of the reasons for this was the development of a permanent Federal deficit after 1969. In the absence of fiscal balance, it is necessary to raise interest rates to combat inflation. This was not done in the early-1970's when significant inflation first appeared. As a result, inflation surged out of control. Fed Chairman Paul Volcker was forced to raise interest rates to unprecedented levels in 1981 in order to crush inflationary forces. These interest rate hikes led to the most severe recession since WW II.

Figure 5. Trends in interest rates and investment since 1950

The 1980's tax cuts and military buildup led to unprecedented peacetime deficits. The presence of inflationary deficit spending meant interest rates had to stay very high to keep inflation from reappearing. Interest rates did not return to reasonable levels until the early 1990's economic doldrums that got President Clinton elected. Rapidly falling deficits after the 1991-93 tax increases produced a disinflationary impact that allowed interest rates to stay low during the 1990's expansion. These low interest rates in the face of low inflation led to a pick up in investment and overall prosperity during the 1990's.

Interest rates were cut sharply following the stock market bubble peak in 2000 and again following the real estate bubble peak of 2005 to prevent a serious economic downturn. Deficit spending has risen during this same time, opening he door to inflation. Interest rates cuts made to avert economic catastrophe do not encourage businessmen to take on risk. Business investment failed to return to 1990's levels and economic performance has been poor despite low interest rates and low taxes.

It would appear that tax cuts do not perform as expected because each time some other factor intervenes to override the expected benefit. In the 1980's it was high interest rates. In the 2000's it was collapsing asset bubbles. As discussed earlier, tax cuts on capital gains will encourage asset bubbles, the collapse of which overrides any stimulative effect of lower tax rates on investment. Similarly, tax cuts lead to deficits which result in high interest rates Through these mechanisms, tax cuts act indirectly to reduce potential growth; tax cuts should not be expected to improve economic performance.

Effect of tax rates on economic performance: what does the long-term record show?

The data shown so far do not demonstrate a clear relation between taxes and economic performance. What had been shown is that lower taxes do not produce a positive impact on growth. To explore this issue further it is instructive to look at the long-term record of different styles of economic policy.

Table 1 shows growth in GDP/worker over decades since 1860. I chose this ratio as a crude measure of productivity for which 19th century data is available. The data for the 20th century and after was periodized in terms of business cycle peak to peak. This was done because trend comparisons should be made from the same point on the business cycle, otherwise part of the cycle effect will be added or subtracted, distorting the picture. For example, growth over the 1920-1930 period was 1.4% compared to 2.3% for 1930-1940. This result is completely contrary to the observed facts of boom times in the 1920's and depression in the 1930's. The 1920-30 period is invalid for determination of the trend in growth because 1920 and 1930 are not the same point in the business cycle. When calculated from business cycle peaks in 1920, 1929 and 1937, growth rates of 2.3% and 0.7% were obtained from the 1920's and 1930's. These rates are consistent with the observed reality of a 1920's boom and a 1930's depression.

Table 1. Growth in GDP/worker since 1860

Decade Period
Growth in
Decade Period Covered Growth in
1860's 1860-1870 1.5% 1940's 1937-1949 3.2%
1870's 1870-1880 2.6% 1950's 1949-1960.25 2.7%
1880's 1880-1890 0.3% 1960's 1960.25-1969.75 2.5%
1890's 1890-1899 1.9% 1970's 1969.75-1981.75 0.8%
1900's 1899-1910 1.0% 1980's 1981.75-1990.5 1.4%
1910's 1910-1920 1.1% 1990's 1990.5-2001.25 1.6%
1920's 1918-1929 2.3% 2000's 2001.25-2008.25 1.6%
1930's 1929-1937 0.7%  
Period Dates Average
Effective Tax
Classical Era 1860-1937 1.5% <10% 4.5%
Keynesian Era 1937-1981.75 2.3% 30% 0.7%
Neoclassical Era 1981.75-2008.25 1.5% 26% 4.7%

*Effective tax rate is government revenues divided by personal income less $7000 times total workers. The values presented are revenue-weighted averaged over the period.

Also shown is something called the effective tax rate, which is defined as follows:

  1. Eff Tax Rate = Govt Revenue / (Personal Income - $7K x work force)

Government revenue divided by personal income is a measure of the overall tax rate. But when the income tax was first set up it was intended that most workers would not pay any income tax at all. I estimated the median income at that time as about $7000 in 2000 dollars. I considered income less than $7000 as not really "available" for taxation and so subtracted this income from total personal income (and entry in the Commerce Dept GDP tables). This sum is a crude estimate of the amount of income that is practically available for taxation. The effective taxation rate thus represents the fraction of income that could be taken without serious unrest. It measures the harshness of the tax regime as implemented, loopholes and all. I do not have sufficient data to even estimate effective tax rates before 1937. As federal revenues as a percent of GDP were much lower before 1937 than they were after, I conclude that effective tax rates before 1937 were very low, less than the ~10% value of the late 1930's.

The dataset is divided into three periods based on the style of economic policy favored. Both the classical and recent neoclassical periods featured high real interest rates for inflation control and relatively low tax rates. As discussed earlier low tax rates lead to asset bubbles. The classical era saw as regular series of asset bubbles whose collapse produced financial panics in 1819, 1837, 1853, 1873, 1893, 1907, and 1929-33. The classical era ended when the Crash of 1929, led to a depression from which the economy could not recover on its own. Panics could not longer be permitted and a new policy was required.

During boom times economic growth during the classical era was spectacular, reaching levels of 10% in the expansions before and after the Panic of 1873, but this growth was offset by contraction during the depressions. Productivity growth ran at 1.5% over the long run.

The neo-classical era differs from the classical era in that economic policy is actively administered by the Federal Reserve, as opposed to the passive control provided by the gold standard policy used during the classical era. Otherwise its goals (price stability) and means (interest rate manipulation) are the same.

Active control means that interest rates are typically cut when a bubble collapses, preventing a panic and subsequent depression. Overall growth has been the same (1.5%) as it was during the classical era, but instead of panic and brief depression, we get lengthy slumps and slow recoveries. As a result growth during expansions is tepid. The fastest annual GDP growth rates measured since the return of bubbles in 1987 have been just under 5%, half that seen during the classical era. Thus, modern neoclassical policy gives the same overall performance as classical policy, but it is less "bumpy".

Between the classical and neoclassical era was the Keynesian era. Keynesian policy was orientated towards maintaining full employment, with price stability a secondary return. Policy still made use of interest rates, but also taxation, government spending and during wartime, price and wage controls. Taxation and Spending did not serve to "steer" the economy (like interest rate police does today) but more as "economic guard rails" that kept the economy on the road to prosperity. Government spending for unemployment insurance, provided demand support during downturns while things like social security, defense and R&D spending provided a source of demand independent of the business cycle. High capital gains taxes prevented serious asset bubbles, which meant rapid recovery from recessions and the potential for better growth. High income taxes in general suppressed most kinds of investment, which led to a disinflationary environment, as long as the budget was balanced. The importance of deficit control is shown by the rapid rise of inflation after deficit control was lost in the early 1970's.

This disinflationary environment permitted the use of low interest rates during expansions to encourage growth. Growth rates during expansions were considerably higher (~7%) than they were in the later neoclassical period, reflecting these low interest rates. The absence of bubbles meant no lengthy slumps as we have today. The combination of faster growth during expansions and short recessions meant better economic performance on average. As shown in Table 1, productivity growth averaged 2.3% during the Keynesian era as compared to1.5% for the periods before and after.

Since the dominant political faction during the Keynesian era was the Democratic party, and their ideology is typically described as "liberal" I call the policy of the Keynesian era as liberal economic policy. Similarly, because the dominant political faction of the classical and neoclassical periods was Republican and their ideological is described as conservative I denote the low tax policy of both eras as conservative economic policy. This historical comparison suggests that liberal policy (i.e. high tax rates, balanced budgets and low interest rates during expansions) gives superior results for ordinary working Americans.

How does liberal policy work to produce superior economic performance?

Liberal policy generates faster growth because interest rates are low during economic expansions. Given this, why don't conservative policy makers today use low interest rats to generate stronger growth? The reason is that low interest rates are inflationary. Policy is based on the idea that the economic as a maximum growth rate that can be achieved without inflation. This economic "speed limit" is represented by what is called the "natural level of unemployment" or NAIRU, which stands for Non-Accelerating Inflation Rate of Unemployment. When unemployment is below the NAIRU, inflation rises, when unemployment is above the NAIRU inflation falls.

During good times, when policymakers see evidence of rising inflation, they increase interest rates in order to discourage job-creating investment so as to increase unemployment and slowing inflation. As described earlier, when the economy appears to be falling into recession, policy makers cut interest rates (regardless of perceived inflation) in order to stimulate investment and job creation in those industries that are still strong. This "counter-cyclical" policy is intended to blunt the severity of the economic downturn. We saw this in the 2001 recession, in which interest rate cuts produced a boom in real estate values that gave rise to a boom in housing construction and mortgage issuance. This boom countered the decline in other industries to give a mild recession following the collapse of the largest stock market bubble in US history.

This interest rate policy avoided a serious recession, but, in combination with tax cuts, it helped create another bubble in real estate. The collapse of this bubble now is now affecting the economy adversely. The close spacing of the two bubble collapses is an important factor in the poor economic performance over this decade. Based on this experience, we can say that low interest rates have been a problem rather than a panacea in the modern era. How were liberal policy makers able to keep interest rates low without significant inflation for decades after WW II?

I mentioned earlier that high tax rates created a disinflationary environment, which allowed the use of low interest rates without producing inflation. Put another way, we can say that the NAIRU was lower then. I also noted that balanced budgets were required to get this environment. As we have run deficits during most of the neoclassical era perhaps this is the reason policymakers cannot run low interest rates today.

Balanced budgets alone cannot guarantee lack of inflation in the face of low interest rates, however. If they did, then either interest or inflation rates during the 1990's era of budget surplus would have fallen a lot farther than they did.

The reason why we did not see a deflationary economy in the 1990's this didn't was the vast amount of financial activity in that decade, as typified by extraordinary bull market in stocks. Rising prices of financial assets (itself a form of inflation) spills over into inflation in the real economy through "wealth effects". In particular, rising home prices created equity that was directly converted into demand through home equity loans.

Put more abstractly, the quantity theory of money holds that price is proportional to the volume of money and rate of circulation relative to the volume of economic output. Even if money growth is held to the rate of economic growth (which it was), inflation can still occur if the volume and rate of dollar transactions per unit of GDP increases.

To see this we can compare the 1990's to the 1960's. Both decades featured strong growth with low inflation and a bull market in stocks. Both decades ended with a speculative frenzy: the "go-go years" in the 1960's and the ‘net boom thirty years later. In both decades money growth did not rise relative to output. From the end of 1990 to the end of 2000, M3 money supply rose from $4.1 to $7.2 trillion or 75% while GDP rose from $5.8 to $10.0 trillion or 72%. The situation was similar in the 1960's; M3 money supply rose from $300 to $616 billion (105%) while GDP rose from $485 to $1005 (107%).

The growth in financial activity was greater in the 1990's than in the 1960's. As an example, transaction volume on the stocks in the Standard and Poor's 500 index (S&P500) rose six-fold during the 1990's compared to 3.6-fold during the 1960's. Volume on the NASDAQ index rose ten-fold in the 1990's.

The sheer size of financial transactions in the 1990's dwarfs those before 1980. Considering just the stock market, the 110,000 share/day S&P500 trade volume at the end of the 1960's translates to roughly $2 billion annually, 1/300th of the GDP. In contrast, the 1.2 billion share/day S&P500 trade volume at the end of the 1990's roughly translates to $15 trillion annually, 50% larger than the GDP. Transactions in the currency markets today dwarf stock market transactions.

It seems clear that financial market transactions were not a major fraction of money transactions in the 1960's and so they did not impact inflation. With money supply and the deficit under control, inflation was controlled without resort to high interest rates. The situation in the 1990's was different. Financial market transactions make up the majority of money transactions and so determine the inflationary character of the economy. Strong growth in financial activity produced its own inflationary effect independent of money growth or the deficit. That is, to counter inflationary forces produced by a rapidly growing financial economy, the real economy growth must be suppressed.

But why has the financial economy grown so large compared to the real economy? Consider the relation between stock market transaction volume and price. In the 1960's, transaction volume rose 260% while the index level rose 80%. In the 1990's transaction volume rose 500% while the index level rose 300%. When one considers stock price rises (the motivation for increasing trade volume) we see that volume rose more relative to the price rise in the 1960's than it did in the 1990's. That is, investor enthusiasm or "bubble-mindedness" was actually greater in the 1960's than it was in the 1990's.

The relative lack of financial activity in the 1960's compared to the 1990's does not appear to reflect a difference in willingness to engage in speculation, but rather, a lack of wherewithal. A major asset bubble did not get underway in the 1960's, despite the "get rich quick" frenzy of the late 1960's, because investors simply did not have enough money to bid the prices of stocks to the levels seen in the 1990's. The late 1960's real estate boom was also a small affair compared to the one in the 2000's for the same reason. The wealth of the investing class relative to the rest of the populace rose in the thirty years between the two periods. This growth in wealth has increased the volume of financial activity, which has imposed an inflationary impact on the economy that has to be countered by higher interest rates (and slower growth).

Figure 6 shows a plot of median income for men1 and the income2 ratio of rich households (those at the 95th percentile) to poor households (those at the 20th percentile). The ratio of rich to poor rose dramatically after 1980. Figure 6 shows that as high income Americans (who presumably have money to invest) have gotten richer, median income has failed to advance, even during the 1990's.

Figure 6. Median income and Income Inequality (1947-2005)

So it in not enough that the budget is balanced. Economic policy that retards excessive growth in investable wealth is needed to prevent the inflationary pressures that prevent the deployment of low interest rate policy. During the Keynesian era, high tax rates aimed at limiting excessive wealth growth was pursued with considerable success.

Figure 7. Returns to wealth over since 1870

Figure 7 shows a plot of the growth (in constant dollars) of a hypothetical investment portfolio since 1870, accounting for changes in investment returns and tax rates over time.3 Also shown is the largest U.S. fortune over the same period of time.4 The similarity of the shape of the two curves suggests that the hypothetical portfolio does a reasonable job of representing how great wealth has fared over time. This figure shows that great wealth did not grow during the Keynsian era, but did grow both before and afterward.

Obviously, the high taxation and low interest rates of the Keynesian era prevented the accumulation of vast reserves of investable funds by the richest Americans. In the absence of such reserves it was not possible to ignite inflationary forces outside of the banking system controlled by the Federal Reserve. Thus, it was possible to run a low interest rate, high-growth economy, which led to unprecedented productivity growth (Table 1) and income growth (Figure 6).

Low taxes create rising economic inequality and federal budget deficits, both of which are inflationary. To control inflation, job and income growth must be suppressed by high interest rates or by recessionary post-bubble slumps. High taxes control the growth of wealth, and with spending restraint, can produce balanced budgets. Under a high tax regime, low interest rates are permissible and faster economic growth can be maintained, leading to the sort of widespread prosperity seen in the postwar era.


The available evidence indicates that not only do tax cuts not spur economic growth, but that high tax rates, when combined with balanced budgets, can actually promote faster growth. This is not the full story. Another key factor is the existence of leading sectors,5 rising industries whose exploitation provide a catalyst for growth. An effective plan for restoring the vitality of our economy would have to make use of both improved policy (higher taxes and lower interest rates) and efforts to develop new leading sectors.


  1. US census: http://www.census.gov/hhes/www/income/histinc/p16.html
  2. US census: http://www.census.gov/hhes/www/income/histinc/h01AR.html
  3. The return on capital was estimated using a hypothetical portfolio of investments. The starting point was an initial investment of $1.50 of 1999 dollars made in 1800. Before 1971, the portfolio consisted of a mix of 50% stocks and 50% bonds. Stocks were represented by an index analogous to that used by Jeremy Siegel in his book Stocks for the Long Run. Bonds were long-term government bonds before 1857 and a 4:1 ratio of long-term corporate bonds and short-term debt (commercial paper and t-bills) after 1857. After 1971 a 10% investment in gold was substituted for part of the long-term bond component. This portfolio is designed to reflect an intelligent asset allocation that might be used by an investor attempting to maximize her return in all kinds of markets over the long run. After 1916, the top income tax rate is applied to all interest and dividend income and the top capital gains rate is applied to all capital gains. The portfolio is assumed to be completely turned over once per year with all capital gains and losses taken (and taxes paid) in each year.
  4. Phillips, Kevin, Wealth and Democracy: A Political History of the American Rich, New York: Broadway Book, 2002.
  5. Leading sectors refer to clusters of related industries that collectively grow faster than the economy as a whole. The innovation school of economic development, founded by Austrian-American economist Joseph Schumpeter, postulates that economic growth stems from innovation leading to these leading sectors is the key cause of economic expansion. American author Harry Dent has described a simple version of these ideas which he calls innovation waves which I present in reference 6. American political scientist George Modelski has identified a series of periodic innovation waves going back for centuries, which are based on particular leading sectors.
  6. Michael A Alexander, "The Innovation Wave and Secular Market Trends" Safehaven, April 7, 2001


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