Déjà Vu All Over Again?
Tuesday November 20 05:15 PM EST
IT SEEMS AS THOUGH investors, not economists, have become Wall Street's most popular fortunetellers. If history is any guide, then the recent flurry of activity in the financial markets suggests that investors believe the end of the recession is imminent — and the interest-rate-cutting cycle likely over.
In the past, the markets have been reliable indicators of economic turning points. In fact, the stock market has turned down before or at every business-cycle peak since World War II and has always begun to recover before a recession's end.
Then again, the economic disruptions of the past few months are unprecedented — as is the Federal Reserve (news - web sites)'s relative inability to stimulate growth. This prompts a question: Have investors turned too bullish, too soon, this time around?
That's a fear shared by many Wall Street economists. ``The markets' behavior is based on hope, not hard numbers,'' says Goldman Sachs economist Jan Hatzius. ``At this point, I don't think the data's telling you that things are improving.'' Mike Evans, chief economist at the American Economics Group, a Washington-based consultancy, agrees. ``Investors are trying to get in on the basis of false optimism.... I don't think [the markets] are going to be a good indicator this time.''
To be sure, the stock market, which typically turns upward an average of five months before the economy rebounds, is pointing to better times ahead. Tuesday's broad decline notwithstanding, the Dow Jones Industrial Average and Nasdaq Composite are back in bull-market territory, up 20% and 32%, respectively, from their Sept. 21 lows, while the broader Standard & Poor's 500 index has gained 18% over the same period. Moreover, the most economically sensitive sectors within the S&P 500 — consumer cyclicals, technology and basic materials — have been among the best performers. ``The market is saying this will be a garden-variety recession'' that ends by March, says Deutsche Banc Alex. Brown senior U.S. economist Cary Leahey.
And it's not just stocks that are trading on the recovery theme: Treasury bonds have reversed all of their declines since Sept. 11 during the past two weeks. The yield on the benchmark 10-year note has soared 69 basis points to 4.60% since Nov. 7, while two-year yields have gained 64 basis points to 2.92% over the same period. Likewise, investors are increasingly willing to take on the added risk of corporate debt. Although the supply of corporate bonds is rising, yields have sharply contracted, narrowing the spread between Treasuries and corporates — another historical predictor of economic recovery.
Given this newfound optimism, it's not surprising that the federal-funds futures contract, which until recently put the probability of another interest-rate cut by the Federal Reserve at around 80%, now puts the chances of just a quarter-point when the Fed meets on Dec. 11 at 45%.
At least some of this market repricing seems justified. On Tuesday, the Conference Board (news - web sites) lent support to the recovery theme, reporting that its index of leading economic indicators — a (by no means foolproof) gauge of economic conditions three to six months out — unexpectedly rose in October. Although the risks remain to the downside, ``the probability that we may be out of this thing sooner than we think has gone up,'' says Leahey.
For that, we can largely thank the military campaign in Afghanistan (news - web sites) and domestic intelligence agencies, whose actions against terrorism have helped bolster consumer and investor spirits. ``I feel better about the economic situation primarily because of the very successful military action in Afghanistan,'' says Mark Zandi, chief economist at West Chester, Pa.-based consultancy Economy.com. ``It raises the likelihood that there won't be further terrorist attacks, which was the most significant risk to the economy.''
And there are other risks that appear to have diminished. Despite predictions to the contrary, the economy's last shoe — the consumer — has yet to drop. Largely because of 0% financing, auto sales soared 33% to 21.3 million units in October, causing most of last month's record 7.1% increase in retail sales. And the recent decline in oil prices to $19 a barrel from roughly $28 this summer will only help boost future purchasing power by as much as $25 billion this winter if price declines are sustained, according to UBS Warburg.
Of course, whether consumers spend or save this windfall will depend largely on labor-market conditions. Yet here, too, there's reason for hope. Weekly filings for unemployment benefits have fallen from a peak of 533,000 immediately following the terrorist attacks to below 450,000 in the past week. ``If claims don't go back up toward 500,000, then the recession is probably over,'' says ISI Group chief economist Ed Hyman, until recently one of Wall Street's most bearish bears.
But some economists say recent economic figures should be taken with a grain of salt. ``The October data set was going to look stronger than the September data set,'' explains Hatzius, because some of the pent-up consumer demand following the Sept. 11 attacks was pushed into the following month. ``The data don't tell you much about the underlying trend,'' which remain predominantly weak, he adds.
For evidence, consider October's rosy retail-sales numbers. While it was certainly good news that consumers responded to sales incentives by auto manufacturers, economists suspect that today's sales will come at the expense of future sales. ``You don't really understand the October data until you see the November data,'' says Leahey. ``We may soon discover that Detroit was just borrowing from the future, robbing Peter to pay Paul.''
The labor market is another case in point. Although initial jobless claims have fallen from their postattack highs, they remain 10% above the levels that prevailed before Sept. 11. And since many businesses must give laid off workers 60 days' notice, the bulk of the layoffs announced after Sept. 11 have yet to be implemented. Moreover, the total number of unemployed workers collecting benefits on an ongoing basis remains disturbingly high. In the past week, continuing claims spiked by 126,000 to an 18-year high of 3.8 million, suggesting that the pace of hiring has stagnated even if the rate of firing has slowed.
Despite these significant caveats, investors are behaving as if a strong recovery looms right around the corner. They may be assuming too much. ``Investors think the economy will turn around about as rapidly as it turned down,'' says Wachovia Securities economist Mark Vitner. ``But we really don't know how strong or universal that recovery is going to be. It may not be strong enough to drive corporate profits that much higher.''
If that turns out to be the case, count on the stock market selling off again, as it has following other false turnaround signals. Remember this spring, when between late March and late May the 10-year Treasury yield rose 75 basis points and the S&P 500 index rallied 18% on the conviction of an imminent turnaround? Similarly, once in 1974 and twice in 1982, the markets staged misleading minirecoveries in anticipation of a quick end to those recessions. ``All of this suggests a risk of tautological reasoning reminiscent of Yogi Berra,'' says Lehman Brothers senior economist Ethan Harris. ``The market is right unless it's wrong.'' |
