Market Plunge Will Wall Street choke recovery? If meltdown continues, all bets are off

San Francisco Chronicle ^ | July 21, 2002 | Sam Zuckerman, Chronicle Economics Writer

[sarcasm]

The carnage on Wall Street has gotten so bad that it threatens lasting damage to the economy, experts now warn, and could kill a recovery that has barely taken hold.

The market crash is reverberating far and wide, evaporating wealth and confidence, and slowing the pace of economic activity. The free fall in stock prices is likely to impede growth and keep jobs scarce for months to come, economists say.

[sarcasm]

WATCH OUT FOR DOUBLE SLUMP

By TERRY KEENAN

---

BAD NEWS:
Morgan Stanley Chief Economist Stephen Roach still believes in a double-dip recession. Conference Board Economist Gail Fosler is at left.
- AP

July 21, 2002 -- AS the stock market continues its mid-summer swoon, much has been made of the hopeful signs that the economic picture is a lot healthier than the sickly stock market suggests.

Indeed, it looks like the U.S. economy grew at an average annual rate of about 4 percent in the first six months of 2002 - the same period in which the Dow lost 20 percent and the Nasdaq cratered to five-year lows.

Obviously, there's a disconnect but is the stock market wrong?

Why do so few consider the possibility that the chasm will narrow as the economy stoops to the market's foreboding forecast?

Sure, the world's greatest discounting mechanism can be wrong - and often early - when it comes to economic forecasting. But it is right more often than not.

So what is the market saying? A lot, and most of it is not good.

Behind the falling stock prices, the market is screaming that the twin engines of growth - retail spending and housing - are starting to stall.

Since Wall Street began its post-Independence Day fireworks the Dow has lost about 11 percent of its value, but key home-building, auto and retail stocks have doubled that dismal decline.

Among home builders, Toll Brothers and Ryland are each down about 20 percent since July 5 - even before news that housing starts in June fell by a surprising 3.6 percent. Retailing stocks are much the same, as the granddaddy of them, Wal-Mart, has plunged 15 percent in the past two week and now sits at its September low.

Meantime, shares of credit-card issuers such as Capital One and MBNA have around 40 percent in the past month, clearly suggesting that something on Main Street may be amiss.

These dog days for the Dow have confirmed predictions of a tiny camp of economists who have been warning that the economy could "double-dip" back into recession.

Leading the double-dippers is Morgan Stanley chief economist Stephen Roach, who's now worried corporate America's "crisis of confidence" will turn into not only weaker consumer spending but more corporate belt-tightening.

In other words: if the CEO can't use fuzzy math to make the numbers - old fashioned cost-cutting and layoffs will have to make up the difference.

The fact that consumer debt service is at record highs, even with interest rates at 40-year lows, doesn't help either.

Roach was the first and strongest voice on Wall Street in predicting the 2001 recession. Now that Mr. Market has joined him in the double-dip posse - it's hard to bet against them.

[jamaksin]

Anyone arrested yet?

[dennisw]

bad news

[sarcasm]

I have a feeling that it's gonna get a lot worse; the hangover from the 90's will be a doozy.

[snooker]

Let's see ... who was it that said he was managing a soft landing for the economy?

If you answered 'the world's smartest man who couldn't see doubling oil prices would have a big effect on the economy so he raised interest rates anyway?' Yep you got it.

And what can we do about it? Nothing.

[sarcasm]

Stocks may drag down economy

Tumbling stocks grabbed headlines last week, obscuring fresh signs of a resurgent economy.
<!ENDSUMM!>

And if Wall Street's battering doesn't end soon, experts warn, it could take a major bite out of the burgeoning economic recovery. How much further, they ask, can stocks slide before consumers put the brakes on the spending that drives two-thirds of the nation's economy?

On Friday, that question mounted in importance as the Dow industrials shot past their post Sept. 11 lows, capping a crushing 25 percent plunge since mid-March. On March 19, the Dow peaked for the year at 10,635.25. Since then, the blue-chip average has lost more than 2,600 points, closing Friday at 8,019.26.

Some economy watchers say the markets could temper the economic recovery. But others fear the worst - a return to recession, with more job losses and related woe.

``We are going to see a slowdown in the economy, there's no question about it,'' said S.P. Kothari, a Massachusetts Institute of Technology accounting professor.

Most experts aren't as certain as Kothari that the stock market will drag the economy down. But they're certainly wary about the effects a long-lasting bear market, already stretching for more than two years, will have on the burgeoning economic rebound.

Not long ago, many economists had hoped the resurgence of the economy would eventually buoy the stock market. Now, they're concerned the opposite will happen - that the markets' dismal slide into lows not seen since the late 1990s could capsize a somewhat fragile recovery.

It's hard to predict exactly when that turning point will occur. But Robert MacIntosh, Eaton Vance Management's chief economist, suggested last week that the threshold would be crossed soon after the Dow Jones industrial average fell below its post-Sept. 11 lows.

On Friday, that happened.

The Standard & Poor's 500 and Nasdaq composite indexes already passed that mark and reached 1997 lows earlier this month.

``Breaching and staying below the lows we had on Sept. 21 could start that process,'' MacIntosh said. ``That's the point where you're going to have enough people frustrated . . . that they likely will not go out and buy that extra set of stereo speakers or they won't buy that higher-end SUV because they're just scared of their financial situation.''

Fred Breimyer, State Street Corp.'s chief economist, said the stock markets' precipitous decline will also make it difficult for many companies to expand because they'll have a tough time turning to the markets for cash.

So far, consumer spending has held up during last year's economic slowdown and this year's stock market crisis.

That's partly because home prices have kept rising, helped by low interest rates.

``For the average person, the equity in their home is much more important than their equity in the stock market,'' said Nicholas Perna, an economic consultant in Ridgefield, Conn.

Federal Reserve Chairman Alan Greenspan last week told Congress that the nation's economy has survived a variety of challenges, including last September's terrorist attacks and numerous corporate accounting scandals. He predicted that the economy is ``poised to resume a pattern of sustainable growth'' - barring any future ``adverse shocks.''

While Greenspan remained optimistic in his remarks, he offered no guarantees. And several experts said his words clearly reflect a concern that the stock market's downward trend could eventually take a toll on the economy.

Alicia Munnell, a management professor at Boston College, said she expects people will cut back on spending as they watch their investments shrink.

``On the downside, you see your savings dwindling,'' Munnell said. ``These huge declines in stock are going to have to, at some point, affect consumer spending.''

Some people may also fear that their jobs are in jeopardy as company stocks keep falling, said state Division of Employment and Training economist Elliot Winer.

``The economy itself is not doing all that poorly right now,'' Winer said on Friday. ``But maybe things might deteriorate more if we don't snap out of the financial quagmire we're in.''

Not everyone's convinced the economy is in trouble.

Wayne Ayers, chief economist at FleetBoston Financial Corp., said he doubts an ongoing freefall in the equities markets would lead to a new recession.

``It may make consumers more cautious, but it will have a minimal effect on consumer spending,'' said Ayers, citing the fact that, for most people, homes are their biggest investments.

Northeastern University economist Andrew Sum said he doesn't think the prolonged bear market, as it stands now, will have much of an impact on the overall economy.

He said changes in home values are a bigger factor in consumer spending. He said people are much more willing to spend from the wealth in their homes than from the wealth that's built up in their stock portfolios.

``As long as the housing market stays strong and as long as people stay reasonably sure in their jobs, you won't see a big effect,'' Sum said. ``(But) if the Dow fell another thousand points, all bets are off.''

[tomahawk]

Many stocks are undervalued now. I'm a buyer.

[PGalt]

Exactly

[meenie]

This not supposed to be happening! The Fed through their open market committee is supposed to fine tune the economy and keep depressions from happening. Why don't our financial gurus lower interest rates further and stimulate the stock market?

Could it be that foreign investors are leaving the US market for higher returns elsewhere? Does the trade deficit have a bearing on the drop of the dollar in world currency markets? We were told for years that we didn't need manufacturing, that we were a service economy. If the dollar drops further, do we have the manufacturing base to rely on to produce our goods?

The emphasis is on the stock market, as it has been for the last twenty years, but the real bugaboo is the drop in the dollar. The dollar has always been a premium over local currencies in most of the world. If this has reversed, we are indeed in deep doo-doo.

[ghostrider]

Let me pose a few simple question for all these "New Market/New Era" clowns.

How can the job market improve, when the jobs are being exported overseas?

How can the market recover, if we quit exporting jobs overseas and accept the high rate of inflation associated with the higher labor costs in the USA?

These "New Market/New Era" clowns have thrown the nation into an Economic death spiral from which it will be hard to recover. Those best ever years of the 1990's, like those best ever years of the 1920's came with a very high price. Now Lucifer will come to collect his due. Historically, there has been one way out of Economic death spirals - "war." Did I say "WAR!" Read your history and decide for yourselves. Hmm! Come to think of it, another World War has already started.

[sarcasm]

Higher costs for imports > inflation > higher interest rates > collapse of housing market.

[David]

The "Double Dip" lable is misleading--there has never been any first dip yet. The rate of expansion of the economy began to slow in March, 1999; government numbers, and the only fact in support of the proposition that we had the recession and ought to be going back up is that we had a single quarter (which does not even meet the commonly accepted standard definition for a recession) where GDP contracted. My own view is that even that fact is a phony--the actual in fact expansion in GDP was moved forward to support the political position that the economy was improving.

If you just chart the GDP on a quarter by quarter basis, you see a decline in the rate of expansion. You also see promotional Government activity on a quarter by quarter basis--almost certainly GDP that actually occured in 2001Q4 was pushed forward into 2002Q1; further, much of the real GDP increase in 2002Q1 was production for inventory which is not sold (the car companies have agreed to pay workers to make cars whether they are working or not so it is cost effective for GM to build cars at a loss for inventory and sell them at a further loss if the economy actually does recover someday); but a continuous chart for the period shows that overall, production by the economy continued, and there was a continued increase, but the rate has been slowing since 1999.

The stock market was extremely overpriced throughout the later period of the expansion--the only excuse for that was that the investors were convinced that the economy and corporate earnings would continue to increase so that these enterprises would some day make enough profit to justify prices. Not a very realistic expectation but they did it anyway.

Beginning in early 1999, investors began to wake up to the fact that earnings growth was slowing; that earnings would never justify prices; and stock prices start down toward reality. I have restated earnings for a number of S&P Companies from released earnings to my view of a realistic comparable GAAP (Generally Accepted Accounting Principals) number and I believe it is reasonable to say that even after the sell off over the last few months, we are now at a Price/Earnings ratio for the S&P of around 35-40 which is an extraordinary high.

There does not appear to me to be any reasonable basis on which you can see an expansion of the economy at any immediate point--we have no savings, no domestic investment capital, excess levels of debt at the consumer, business, and government levels; and after tax rates of return on investment are so low as to discourage any capital formation activity.

So the economy is going to continue to deteriorate into a real contraction of GDP, an in fact first dip recession; and stock prices are going to continue down to P/E ratios that reflect reality.

meenie's point about the dollar is well taken--but in the short term, the dollar's exchange rate slide against the yen, the euro and other currencies is not as serious a problem as it might be because those currencies are the reflection of economies which are in as bad shape as our own and for which improvement relies on improvement in the US which is not going to happen.

The Canadian Looney may be an exception--they are a resource production based economy and may well ride this out better than others--they may not.

The real problem with the dollar is the exposure to a complete breakdown in the system in which derivative collapse implodes the fiat dollar support--that may be an argument for physical gold.

[Soren]

Many stocks are undervalued now. I'm a buyer.

What sectors are you looking at? I've heard there are some good values in the oil/gas and energy sectors, but I haven't investigated it yet personally.

[Soren]

Excellent post. I seem to recall reading that restated GDP stats for the last few (5?) years were going to be released on 7/31. If so, that could be interesting. Another point in support of your view is that government spending is included in GDP, if I'm not mistaken. One area where I differ a bit from you is with regard to the US$. I think the fall in the dollar is very important because of the level of foreign investment in the bond and stock markets and the level of the current account deficit (which requires a continual inflow of foreign funds).

[A. Pole]

Let's see ... who was it that said he was managing a soft landing for the economy?

The same guy who said that there is a deadly danger of 2% inflation. I am not an expert but I think that he(they?) should have stopped tightening of the screw in the moment when stocks started to go down and not to wait long time until the collapse started.

[rodeocowboy]

I think that Bush should completely scrap his whole budget, downsize the federal government by 2/3, mail a huge tax rebate to every person who paid taxes last year, and propose to make permanent the 66% reduction in federal spending. You can't cut taxes and spend like Bush does. He needs to veto any budget that comes to his office that does not coincide with the above. Then, and only then, will he make the economy BOOM!

[gaffin]

The boneheads in Washington are most of the problem.They refuse to cut spending. Big cuts in spending and quick recover will follow. The only problem is it will never happen.

[cgbg]

Keep your eye on Bay Area real estate.

The Bay Area has some of the most highly leveraged home owners in American and the high tech jobs are fading fast.

There can be a one or even two year lag time between economic hardship and a real estate crash as homeowners spend savings and use credit cards to keep their homes.

Tick.

Tick.

Tick.

[David]

Thank you for the compliment.

"One area where I differ a bit from you is with regard to the US$. I think the fall in the dollar is very important because of the level of foreign investment in the bond and stock markets and the level of the current account deficit (which requires a continual inflow of foreign funds)."

This is kind of a semantics issue--of course at a primary level you are correct--significant fall of the dollar against the euro and the yen (and perhaps gold) may cause foreign investors to stop sending further investment capital in the form of dollar loans and to withdraw funds from the US economy and change them into other currencies. However that will in turn force Congress to face directly the problems created by a tax system that is a disincentive to savings and investment--we need to develop our own capital; it is bad public policy to encourage consumption of almost all spendable income.

Further, it is not altogether clear that a drop in the dollar is likely to have that immediate direct result. In part for the reason originally stated (the immediate drop is likely to be small because the European and Japanese economies are not in great shape either); and in part because if the foreign investors perceive that they do not have effective alternatives, they are more likely to short the dollar in the currency markets than to take their investments somewhere else. But you are right--it does not take much more deterioration in the dollar to cause a problem; and at some point exchange rate slide starts to raise doubts about the overall long term stability of the monetary system (and drive investors into gold).