interactive.wsj.com
Why Gary Shilling still isn't a convert to the religion of a
quick economic recovery
By Jonathan R. Laing
Almost from the official declaration late last November that the U.S. was in
recession, the bulls on the economy and stock market were quick to declare
victory. The trough of the recession was imminent and would be followed as
night by day with a robust recovery in 2002's first quarter, said Wall Street
optimists, noting that post-war recessions have lasted on average, about 11
months and that the current one was deemed to have started last March.
The stock market typically anticipates or "discounts" recoveries by four to six
months. Therefore, the sharp rallies of over 20% in the Dow and Standard &
Poor's 500 and 45% in the Nasdaq since the September 21 post-terror-attack
lows both point to an impending rebound in the economy and a potential boost to
flagging consumer and business spending.
The bulls also say that 11 straight rate cuts by the Fed, including one last month,
should shock the comatose economy back to consciousness soon. If this proves
insufficient, post-attack fiscal stimulus should do the trick.
All of this, however, leaves economist Gary Shilling less than impressed. The
proprietor of the Springfield, New Jersey, research firm A. Gary Shilling & Co.,
in fact, had been predicting a nasty recession and stock-market correction for
the past couple of years. "The official recognition that the expansion had ended
in March [2001] was something of relief for us since we'd maintained since
February [2001] that the U.S. had slipped into recession," says Shilling, who
sees rising unemployment, falling profits and limp production lasting at least into
the third quarter.
Likewise, he sees another sharp
drop in the stock market between
March and May that, he says,
probably will be deeper than the
emotion-induced lows set in
September when the Dow sank to
8236, the S&P to 966 and the
Nasdaq, to 1423. Over a year ago,
he used various valuation measures
to set targets -- still in force -- of
where the selloff would likely end.
He sees the Dow eventually down
30%-40% from its all-time high of
11,723, to 7034-8206, and the S&P
selling off 40%-50% from its
all-time peak of 1,528, to 764-917. His Nasdaq target: 1010-1515, or 70%-80%
below its peak of 5049. Only the Nasdaq penetrated his range on September
21.
According to Shilling, recessions are less predictable than commonly thought.
And the current one is a particularly odd duck, he says.
Normally, says Shilling, recessions have been triggered when the Fed tightened
credit and raised short-term interest rates to cool an overheated economy and
stifle inflation. The first casualties of war were often housing and other
interest-sensitive industries like autos and capital goods. Inventories would build,
leading to slashed production schedules and rising layoffs. Recovery would
come only after inventory excesses were worked off.
To be sure, the current recession was preceded by Fed credit tightening
beginning in June 1999. But the ensuing contraction was initially confined to the
New Economy, weighted down with gross overcapacity from years of
insensate capital spending. Capacity utilization imploded in areas as diverse as
fiberoptic telecommunications and semiconductor manufacturing.
Venture-capital money and bank credit dried up for new technology projects.
Capital spending, normally a late-recession casualty, plummeted early on.
These New Economy problems, in turn, fed back into the consumer economy
when technology stock prices crashed after March, 2000. Many affluent
investors throttled back their spending when tech stock losses suddenly
imperiled their comfortable lifestyles and retirements.
Yet, in the main, consumer spending continued to grow unabated until October
and housing activity continues at a healthy clip. And, the recent bounce back in
stocks only confirms in investors' minds the lesson of the past 20 years: Buy on
weakness because stocks always come back and hit new heights.
But now, argues Shilling, a more lethal recessionary phase is impending, as the
malaise spreads to the Old Economy. Mounting job losses in the manufacturing
and service sectors have caused consumer confidence to crumple. Consumers
finally threw in the towel in the middle of last year and largely used their
tax-rebate checks to pay off debt rather than buy new goodies. Spending is
sliding dramatically. Housing prices show signs of leveling off, a likely prelude,
says Shilling, to actual declines.
Moreover, Old Economy weakness will tend to feed back into the tech area,
Shilling insists. Sales for many tech consumer products are slowing. Palm Pilots,
for example, are considered consumer durables. And, Shilling points out, if auto
sales fall next year as predicted, so will demand for the semiconductor chips
that abound inside new cars.
Shilling also delineates secular trends likely to extend the recession and blight
the vigor of any recovery. For one thing, consumer spending patterns are in a
rapid downshift because of the trauma of September 11, elevated personal-debt
levels, growing joblessness and shoppers' propensity to demand price discounts
and curtail the purchase of non-essential items. Income growth is likely to
suffer from cuts in hours worked (December's rise in this regard was an
aberration, Shilling maintains) and lower year-end bonuses for everyone from
Wall Street investment bankers to auto workers.
Management requests for wage concessions are cropping up with greater
frequency than at any time since the Great Depression. And consumer
spending will be curtailed by the need of Baby Boomers to finally save for
retirement.
Given all this, he suspects that the economy is still careening down the left side
of what will prove a wide U-shaped cycle. Or it may trace a W-shaped
formation with a mild rebound coming in the current quarter, followed by a
resumption of negative growth over the next two quarters. In any case, Shilling
doesn't see a trough followed by a vigorous rebound early this year.
The possibility of a synchronous worldwide recession also looms, according to
Shilling. As a result, export growth won't provide a cushion for the U.S. The
last time the U.S. faced a global downturn was during the bloody 1973-1975
recession.
According to Shilling, most bulls are counting on monetary and fiscal stimulus to
rescue the economy. However, Shilling contends that Fed easing is way
overrated. "Look, the Fed eases at about the peak of most business cycles and
recoveries always follow, but it's equally true that eclipses of the sun go away
when you go outside and beat a drum," he notes. "We always got recoveries
from recessions even before the Fed was created in 1913. The Fed is just along
for the ride in any business cycle. If banks continue to raise credit standards
and corporate and personal bankruptcies continue to spiral, today's credit
crunch will increase in severity, despite all the ministrations of the Fed."
Likewise, fiscal stimulus usually arrives too late to have much impact on
recessions. Of the $40 billion approved in federal relief spending passed three
days after the September attacks, only half of the funds have been appropriated
and a tiny fraction actually spent, says Shilling. And the supplemental stimulus
package continues to be mired in partisan bickering in Congress. Finally, much
of the federal stimulus will be offset by spending cuts and tax increases forced
on state and local governments, which are constitutionally required to balance
budgets.
Shilling insists that economic growth won't get the same push from a rising
stock market in the years ahead that it did in the 'Nineties. For one thing,
stock-market valuations remain at nose-bleed levels even after the selloff that
began in March 2000. And many of the artificial spurs to corporate profits that
drove stock prices relentlessly higher figure to reverse. The capital-spending
boom of the late 'Nineties will inflate depreciation charges. Falling interest rates
and a less ebullient stock market will boost required corporate contributions to
defined-benefit pension plans.
By all means be of good cheer, Shilling advises. But stock investors should be
careful not to overindulge. The hangover could prove painful.
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