Stock Brief by Briefing.com
Updated: 06-Aug-01
Deep Economic Thoughts
Call what you will: a recession, a downturn, or a slowdown, but don't call it over. Recent economic data have lent support to our belief that the economy is not poised to recover anytime soon. But while the economic story might be playing out in ways that are expected, the market is reacting to this information in ways that are best unexpected, and at times downright confounding.
Market watchers have no doubt noticed that on some days, a weak economic report is bad news as it suggests a longer wait for corporate profits to recover. On other days, it is supposedly good news as it points to more aggressive Fed rate cuts. In one recent story we heard on a prominent business news network, the reporter claimed both a positive and negative market response to the same weak economic report inside of a minute! Confused? You should be.
First, let's be clear on this point: the fact that the market moves after an economic report does not prove that the market moved because of that report. Often, we hear reason being tortured in a vain attempt to explain why the market reacted to an economic report the way that it did. Sometimes it's better to look elsewhere for the reasons.
But insofar as the market does care about economic reports, let's investigate what's good and what's bad. The essence of the debate is how any given economic release affects stock valuations, which are themselves based on the discounted value of future cash flow.
It is true that a weaker than expected economic report typically increases the probability of a Fed rate cut. But is that good news? Those who say yes make their case on two fronts.
First, they will argue that a lower fed funds rate reduces the discount rate by which stocks are valued. Yes and no. An interest rate used to discount the long-term cash flow of a company must by definition be a long-term rate. As we have seen for months now, Fed rate cuts do not necessarily have any impact on long-term rates, and therefore it's arguably the case that this year's rate cuts have had little if any benefit on stock valuations via the discount rate effect.
The second avenue for arguing that weak data is positive for stocks is that the weakness will prompt Fed rate cuts, which will in return prompt a stronger economy. It's amazing how often your hear this logic despite how absurdly circular it is. This argument assumes that a stronger economy is a good thing, because that's why we should root for Fed rate cuts. But if a stronger economy is a good thing -- which it is -- why on earth would you want to go through unexpected weakness first to get to strength?! Wouldn't it be better to just have the strength now? Of course it would.
Early in a downturn, when the market often knows that Fed policy is too tight and that profit growth will inevitably slow, a weak economic report will sometimes be positive as it will trigger more aggressive and/or faster move by the Fed without necessarily changing the market's expectations for profits. But we are now eight months past the first easing, and the fed funds rate is at a level that most feel should prompt renewed profit growth. So unexpected weakness at this point in the cycle has to be seen as a disappointment that raises the possibility that the current downturn will be more intractable than the market currently expects. In short: weak economic reports are bad news. The end.
Parting Shots
* The Fed: we have been getting some questions recently about what the Fed will do and when they'll do it. The answer: a 25 bp cut to 3.5% at 2:15 pm ET on August 21. The market is fully discounting this cut, and it will therefore have little impact.
* Productivity: perhaps one reason for the sputtering economy and slipping productivity growth is the fact that there are still hundreds of hopeless dot-coms that are paying workers to operate failing businesses. Instead of sending what cash is remaining back to shareholders who might put it to more productive use, they will spend until there's nothing left. Until the money is gone, productivity growth will suffer from this massive misallocation of funds.
* Cliches: if we hear anything more about "bottoms" or "trains leaving the station" we're gonna crack. Why can't we discuss the real issue, which is what the post-bottom, post-train departure world will look like. The market is still assuming a strong economic and profit recovery awaits in 2002, but there's still good reason to believe that the excesses of the bubble will take much longer to work off. The post-bottom period will probably be characterized by a frustratingly stagnant economy for which the market is not prepared.
* Historical Comparisons: how many times have you heard that the market/economy/sector/stock will recover in x months because that would be consistent with how that market/economy/sector/stock has behaved in past cycles? Seems to us that the Internet/tech bubble was not something that occurred in those past cycles, so why would we expect the post-bubble downturn to be like past cycles? Throw out the historical comparisons, because this is a cycle like no other. Investors would be better served by keeping close tabs on current indicators instead of dusting off historical chart books.
Greg Jones - gjones@briefing.com |
