War Rally Loses Sight of Deeper Risks
By GRETCHEN MORGENSON
Columnist
The New York Times
March 23, 2003
WAGING war against Iraq sure beats waiting for it.
Such is the view of United States investors, who have bid up the Standard & Poor's 500-stock index by 2.5 percent since the war began on Wednesday night and 7.5 percent for all of last week. Investors seem grateful for reports of successes on the battlefield, given that domestic economic news continues to be grim.
Though it is understandable that investors, fed up with a three-year-old bear market, would seize on positive war news as a reason to buy stocks, such a focus is exceedingly narrow. Some market strategists say that it does not take into account some real market risks — and that it means a return to unreasoned and potentially dangerous speculation.
"People are too focused on the war," said Richard Bernstein, Merrill Lynch's senior United States strategist. "Jobless claims are over 400,000 for five weeks in a row, and people don't care. The Philadelphia Fed report is bad; people don't care. I think the argument you will hear from most people is the market's going up and the market is telling you something. If that's the justification for why one should be bullish, it shows that speculative fervor has returned to the market."
Investors may be hoping that history will repeat itself. As James B. Stack, president of InvesTech Research in Whitefish, Mont., noted, military conflicts are often followed by higher stock prices. "We looked at wars and the market, and in almost all cases the market was higher 6 months and 12 months down the road after an initial sell-off," he said. "One important aspect of a conflict is that during times of turmoil, it gravitates the public toward patriotism and that patriotism toward confidence. After the longest bear market in 60 years, what Wall Street needs more than anything is a shot of confidence."
There were also technical aspects to stocks' advances once war seemed certain. Many who had bet against stocks decided to close out their positions rather than be run over by an emotional rally. Investors who had been selling were, at least temporarily, buyers.
Because the market is known for spotting economic rebounds well before they occur, many investors are starting to view the bounce in the S.& P. — almost 12 percent since March 11 — as an indication of the long-awaited turn. But such rallies have occurred before, only to fizzle when the weak economy proved unable to sustain them.
The fact is, the recent momentum in stocks must be backed by higher corporate earnings, which can come only if the economy improves. But corporate spending remains moribund, consumers are nervous, and layoffs keep coming. Stocks are a rare bright spot. Bright, and increasingly expensive.
NE could say we're in a growth recession because we're not really experiencing the level of growth to absorb the labor that's available," said Dimitri B. Papadimitriou, an economist and the president of the Levy Economics Institute of Bard College in Annandale-on-Hudson, N.Y. "Since what has been proposed by the president in terms of fiscal stimulus isn't going to have an impact, and my suspicion is the private sector will continue to rein in expenditures, we are on a recession path."
Perhaps the biggest risk is that consumers will discover the joy of saving. Their spending has kept the economy afloat, but that pattern may be winding down. In a study by NPD Group, a market research company, only 14 percent of consumers said they plan to spend more than usual this spring; 41 percent will spend less.
Crushing consumer debt levels may be forcing these cutbacks. Another likely culprit is continued layoffs. "The debt burden at the corporate level may have peaked," said William W. Priest, a managing partner at Steinberg Priest & Sloane Capital Management in New York. "But at the consumer level it's been masked by rising home values. I think unemployment at the end of this year will be higher than it is today. We are going to struggle most of this year with the fact that final demand will be below most expectations; corporate earnings will be up but probably below expectations."
Consumers seem frustrated about their options. In a survey released on Wednesday, the Conference Board said that 62 percent of consumers rated the investment environment as bad, and that 65 percent expected no change six months from now. Fourteen percent expected investment conditions to worsen, up from 11 percent in September, and 69 percent didn't plan to invest in stocks in the next six months.
Money flowing into mutual funds has been confirming these sentiments. Bond funds are attracting far more money than stock funds. And when investors do put money into stock funds, they are more likely to be funds investing in foreign companies. AMG Data Services said that of the $2.1 billion in net cash inflows to stock funds for the week that ended Wednesday, 85 percent had gone into international and global funds.
Consumers' aversion to domestic stocks may be a result of the perception that corporate earnings cannot be trusted, even now. In the past year and a half, investors have seen repeated accusations of fraud at some of the nation's largest companies, but this storm has yet to pass. In a case brought last week, the Securities and Exchange Commission contended that HealthSouth, a giant health care provider, and some of its executives had committed $1.4 billion in accounting fraud since 1999.
Even if corporate earnings rise in 2003, exacting investors will reduce the reported figures to account for stock options that companies dispense but do not yet show up as a cost. David Zion, an accounting analyst at Credit Suisse First Boston, said options costs, if counted, could take 10 to 15 percent off S.& P earnings this year.
Chief financial officers are increasingly worried about the economy's prospects. In a survey of 186 finance officers last week by Financial Executives International and Duke University, 45 percent said they felt less optimistic. Three months earlier, only 15 percent said that.
All these factors, said Mr. Bernstein, of Merrill, mean that investors should sell into the rallies that euphoria over the war may produce. He said he was mystified that investors seemed to think that success in Iraq could remove geopolitical risks from the investment equation. "We think we're entering a 10- to 15-year period of substantial change in geopolitics, similar to the fall of the Berlin Wall or the demise of the Soviet Union," he said. "But this time we're in the middle of it. We are the target, and we are viewed by much of the world as the instigator. What a change in geopolitics that is." And one that carries very long-term risk.
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