Don't expect a quick rebound
National Post
Saturday » July 20 » 2002
Stock market crashes are not supposed to kill growth, but today's trading chaos is raising doubts. As the markets fall, economic growth is reportedly rising. Will the markets trounce the economy, or will a growing economy revive the markets?
Milton Friedman once said the stock market has predicted 12 of the last six recessions. Today, the economy is growing but stocks are falling. Is this apparent disconnect an example of the Friedman axiom? Will the economy inevitably pull the markets back up?
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William B.P. Robson, vice-president and director of research, C.D. Howe Institute:
Equity markets often seem to misforecast short-term ups and downs in the economy. But whether share prices and the business cycle are correlated is hardly a decisive test of investors' ability to look ahead intelligently.
Changes in the long-term outlook for earnings matter far more for share prices than short-term swings. And investors may be adjusting their long-term expectations in ways that have little to do with the short-term cycle.
An investor with a discount rate of 6% who expects an investment to yield 6 cents a year will pay a dollar for it. If she thinks weak demand in the economy will reduce its yield to 4 cents for one year, she will pay about 98 cents; if she expects 4 cents for two years, her price dips to about 96 cents. But what if she thinks a major blow to the economy's supply side will lower the yield to 4 cents indefinitely? Then her price will plummet to 67 cents. It would take colossally superior short-term yields to offset the long-term deterioration.
Something like that may be happening in North American equity markets. Two years ago, investors saw resources going into new technology, boosting productivity and profits. Government budgets were in surplus and taxes were coming down. If there was a recession, central banks would see it off with lower interest rates. Now, investors see resources going into security and defence, protectionism on the rise, corporate scandals, and possible regulatory overkill in response. The U.S. government is back in deficit; tax cuts are stalled. If the economy's supply side has taken a hit, central banks can't ease without causing inflation and, ultimately, higher interest rates.
Weak equity markets may not signal a short-term slump. But they may reflect a deterioration in the long-term outlook. If they do, it will take more than easier money to raise equity prices again. It will take a major sustained effort by governments and businesses to improve the long-term prospects for the North American economy.
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David Rosenberg, chief Canadian economist and strategist, Merrill Lynch :
History is replete with so-called "disconnects" between the economy and equities. Just go back to 1987, 1994 or 1998 -- weak stock markets, but solid economic growth year each and every time. Even in the "secular" bear market of 1966-81, annual GDP growth was better than 3% two-thirds of the time and 4% half the time. In the final analysis, it is interest rates more than equities that ultimately determine the macro outlook.
In this sense, what matters most is the rate-sensitive housing market. Despite the "equity cult" of the late 1990s, residential real estate remains the most important asset on the household balance sheet. If you want to see a real disconnect -- the reverse of today's backdrop -- just go back to the 1989-93 period. The U.S. economy was soft for a period of four years -- recession, double-dip, jobless recovery -- and yet the bear market lasted only four months. What caused the disconnect back then between a weak economy and decent stock market was that real estate went into a deflationary spiral and sent consumer confidence and spending along for the ride. Fast forward to today, and we have the exact opposite situation to a decade ago: weak equities and a solid economy, and the glue holding the consumer together is a firm housing market. Alan Greenspan expects this to persist, and so do we.
Regardless of what the economy does over the near term, we think the stock market will continue to unwind the excesses of the late 1990s. It's interesting that the word "disconnect" hadn't yet made it to the investment lexicon in the second half of the 1990s when the S&P 500 was galloping ahead by more than 20% per year and the economy growing at barely one-fifth that pace. In the third quarter of 1996, U.S. stock market capitalization moved above 100% of private sector GDP (three months later, Alan Greenspan coined the term "irrational exuberance"), only to then hit an unprecedented peak of 172% at the beginning of 2000. Even with the plunge in stock prices, the grim reality is that this ratio now stands at 107%. Since it generally takes at least 12 months to generate 7% nominal GDP growth, perhaps we can start talking more seriously about a market bottom this time next year, when equity values are finally realigned with the economy and earnings. Hopefully, by then, investor trust in corporate financial statements will have been restored as well.
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Reuven Brenner, Faculty of Management, McGill University:
If investors expect devaluation of the U.S. dollar, they sell stocks. The U.S. economy might then grow in devalued U.S. terms. There is not necessarily a contradiction or paradox when stock markets fall and the respective economies are growing in terms of devalued currencies. It happened in Canada too, remember? That's the answer to the first part of the question. Devaluation can certainly lead to higher measured "growth" -- and often has. Whether the present devaluation in the U.S. dollar is good for the United States and the rest of the world is a separate question.
Will the economy boost the market? Sept. 11 imposed a large implicit tax on international trade and domestic trade within the United States. Instead of lowering taxes to compensate for the large hidden increases, and lowering tariffs on agricultural products, Washington moved, unfortunately, in the opposite direction, imposing additional steel tariffs. This is expected to create bad will and retaliations in the rest of the world. The market anticipates such bad will. Add the large accumulation of domestic U.S. debt -- no longer backed by a rising stock market. The market discounts this bad news too. Add on top the accounting shenanigans. The market drops each time politicians want to legislate the solutions. Investors are weary of the passage of bad laws and regulations, which have VERY long lives.
Briefly: There is no reason to expect that a devalued and mismeasured "economy" will pull up the stock market. Better fundamentals would. Unfortunately, it's the fundamentals that seem to be deteriorating. In spite of this, the United States may still do better than most other countries, because the other countries seem to be bent on committing even worse blunders.
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Sherry Cooper, executive vice-president and global economic strategist, Bank of Montreal Group of Companies:
History is full of instances when stocks and the economy fail to synchronize. The stock market crash in 1987 and the downslide in 1998 in the wake of the Asian crisis were not precipitated by, nor did they lead to, a meaningful slowdown in economic activity. The current meltdown in stocks is a justified reversal of the unwarranted surge in stocks relative to the economy in the second half of the 1990s, and it isn't over yet.
For the decade of the 1990s, as strong as the U.S. economy was, it did not warrant the dramatic surge in equity values, especially for those companies that had little revenue, let alone earnings. The fervour was, as Alan Greenspan had told us, irrational. The ratio of stock valuation to GDP in the U.S. surged to a record 185% in the first quarter of 2000, just before the bubble burst. Historically, the long-term average U.S. ratio has been 74%. In Canada, the exuberance was somewhat more muted, owing in large part to the sizable representation of Old Economy basic-industry companies in our stock market. Even so, our stock-to-GDP rate surged to a peak of 89%, well above the historical average of a mere 33%.
What we are experiencing today is a justified and healthy reversal of that irrational exuberance. Even though the Canadian economy is very strong and the U.S. economy is posting a solid recovery, stocks continue to decline. The downtrend is accelerated, of course, by the continuing revelations of corporate malfeasance and the overhang of terrorist threats. The U.S. dollar is falling because foreigners are selling U.S. assets, particularly large-cap stocks. The stock-to-GDP ratio has now fallen to roughly 105% in the United States and 60% in Canada. Because a growing proportion of corporate earnings is generated in foreign markets, never impacting GDP, the ratios likely need not return to historical norms. But the correction is likely still unfinished. The stronger the economy, the faster the adjustment in the ratio. The economy is not vulnerable, but the stock market still is.
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Craig Wright, chief economist, RBC Financial Group:
The short answer to both questions is yes, hopefully.
The malaise currently affecting equity markets has more to do with unhealthy accounting than an unhealthy economy. Equity markets were in the midst of a transition from greed to fear when certain significant accounting scandals first hit the radar screens; a transition that has only been exaggerated by the scandals. As the earlier highs in equity markets were hard to justify based on the economy, the current lows also seem somewhat disconnected from the economic environment.
If one didn't pay too much attention to the gloom coming from Bay Street, one could be quite bullish on Canada's economic prospects. The economy is expected to rise 5% in the second quarter after soaring 6% in the first quarter, inflation is low, the unemployment rate is falling and over 300,000 jobs were created in the first six months of the year alone -- providing fuel for spending on housing and autos. The evidence suggests this trend will continue as pent-up demand in housing and autos will continue to be released in the months ahead. Strong growth is likely to be accompanied by firming productivity, supporting further gains in corporate profits after a 68% annualized surge in the first quarter of the year. As this takes place, equity markets will be hard-pressed to remain in the doldrums.
Hopefully, this takes place sooner rather than later. The longer the current investor pessimism holds, the more the risk increases that it will spread to businesses and consumers -- two sectors needed to keep the economy powering ahead. This may yet prove to be another example of Main Street having a better read on the economy than Bay Street.
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