Stock Brief by Briefing.com
Updated: 13-Aug-01
Not So Wise
Forecast for the Nasdaq on August 13, 2003: 2,000. Ridiculous you say? Check out a 3-year chart on the Dow. If the Nasdaq repeats that performance, it should be right around 2,000 in two years, repeating the 2+ year trading range seen for the Dow. This is not actually our forecast, but at a time when the conventional wisdom is fairly certain that the market and the economy will both be comfortably stronger in a year's time, it's worth asking what could go wrong with this forecast.
This being America, there is neither much tolerance for nor expectation of stagnation. The economy has only been weak for just over three quarters, which - even if it were a full-blown recession - would only count as a mild recession. But even though the slowdown has been mild and short-lived by historical standards, there is already a building impatience regarding recovery. Analysts and economists talk only of a bottom in profits and the economy.
The last recession was in 1990-91. It was a brief affair, but was followed by a long period of sluggish growth. A year and a half after the recession ended, the phrase "it's the economy, stupid" helped vault Clinton to the Presidency, a reminder of how long that period of economic sluggishness persisted.
We wouldn't draw too many parallels to 1990/91 in terms of the causes of stagnation, but we can see the possibility of a similar result in 2001 and beyond. Throughout this year, we have been discussing the fact that the popping of the investment bubble was the trigger for the current slowdown, and that it might take considerable time for the excesses of the bubble to be worked off. Though this is just an economic forecast and is subject to all the usual risks of economic forecasts, it is notable that the events of 2001 have thus far played out in a manner which is entirely consistent with our thesis.
Business investment has declined, with the pace of decline accelerating in Q2. The decline in investment severely depressed profits in the manufacturing sector. Manufacturers therefore reacted first, laying off workers in an attempt to restore profits. Layoffs then led to slower growth in consumer spending, and thus more widespread sales weakness, and profit weakness, and layoffs, and so on. On that final point, many have noted the resilience of consumers. And while it is true that consumer spending has continued to grow, there has been a steady decline in the pace of growth, from over a 5% year/year pace at the cyclical peak to just 2.1% qtrly growth in Q2. This vicious cycle of weakness played out domestically first, and is now playing out globally.
The likelihood is that business investment, which started it all, will halt its decline toward year-end. But a strong recovery off that low isn't a great bet. Until consumers boost their purchases to the point where capacity is once again strained, a healthy recovery in business investment is likely to wait. Capacity use is at an 18-year low, and this slack will not be taken up with a 3-month uptick in spending. It could take many quarters before more capacity, and thus more investment, is needed.
The key in determining the magnitude and duration of the downturn will be the consumer. If the 2.1% growth in Q2 spending is the worst we'll see, then we probably can hope for a modest 2002 recovery. But if the latest wave of layoffs that accompanied Q2 earnings reports leads to another leg down in confidence and spending, the recovery will come later and be weaker.
A final word of warning regarding conventional wisdom concerns the touting of leading indicators. Back in April/May, when the stock market recovered despite no signs of an economic recovery, it was widely accepted that the market's improvement represented the rational expectation of improved economic performance later in the year. The market does, after all, typically lead the economy. And the Fed had been cutting rates, which would normally produced stronger growth in the next 6-12 months. Even the bond market and gold prices were pointing to a recovery ahead.
Though the market began to falter by June, we then received Leading Indicators reports for the months of Apr, May, and Jun that revealed three straight increases after posting declines in 9 of the prior 11 months. For the optimists, this was still more reason to cheer - here was the evidence of the economic improvement that the markets had already predicted.
Too bad it was circular reasoning.
As it turned out, those three positive readings were the result of the stock and bond market signals. Leading Indicators rose a cumulate nine tenths of a percent over those three months; stock prices and the yield curve accounted for seven tenths of that increase. Another financial indicator - real M2 - is responsible for four tenths. The seven other components of the leading index - those that are related to the real economy - have continued to fall.
Though the markets can at times be good leading indicators themselves, they are not perfect, as the recent bubble clearly established. We would prefer to see some solid indications of improvement from the real economy before getting more optimistic. Investors, having not yet seen that, are now taking stocks and bond yields back down, erasing some of the Springtime optimism, and with it, the Leading Indicators recovery.
In short, it's best not to rely on the current conventional wisdom that economic recovery is imminent. It might be - nothing in economics is ever certain - but the indications we have seen to date do not make a strong case for that view.
Greg Jones |
