Market Disconnects from the Economy
Second Quarter 2002: The Sum of All Fears
Over $1.4 trillion in domestic personal wealth was wiped out in the second quarter of 2002 while the S&P 500 lost -13.8%, the worst quarterly performance in over 30 years. Simultaneously, the NASDAQ Composite declined -20.7% extending its peak-to-present decline off the 2000 highs to down -74%.
Given the essentially flat performance in the first quarter, year-to-date results show the S&P 500 index down -13.1%, bringing the overall decline from intraday high to intraday low since the 2000 peak to down -42%, which is eerily close to the -45% peak to trough decline that occurred in 1973-74. Meanwhile, the already beleaguered NASDAQ Composite is down -25% for the first six months of 2002, a five-year low.
Bonds continued to act as a positive anchor in the capital marketplace and showed excellent results in the first half of the year despite periodic speculation about imminent Federal Reserve Board (“Fed”) interest rate hikes. For the first half of 2002, both the Lehman Brothers Government/Corporate Index and the Intermediate Index were up +3.3%.
The loss of investor confidence in the stock market had little to do with the domestic economy which, although not stellar, appears to be improving steadily after the year-long capital spending recession that began in March of 2001. Rather, market participants have been focused on the continued threat of terrorism in the U.S., the extent and duration of the decline in the U.S. dollar, the degree to which generally accepted accounting practices leave more room for judgment (and, sometimes, manipulation) than previously assumed and, most importantly, corporate malfeasance.
During the high-flying technology years (1995-1999) corporate chief executives and Wall Street technology analysts became market and media stars as an adoring investor public blithely committed the rather common error of confusing genius with a bull market. Stardom is a uniquely isolating condition and the delusions of grandeur it can breed, when mixed with the pervasive corporate need to produce earnings (sometimes where none existed), have led to egregious excesses, at best, and, as we are apparently discovering in some cases, outright criminal behavior.
To offer what we hope is a modicum of perspective, it is probably not an accident that a majority of the high profile confessions have emanated from corporations that were part of the technology bubble. It was in this arena that the star system was most evident and the creation of earnings to justify premium valuations most exigent. While certainly not confined to technology-related industries, revelations of aggressive or questionable accounting practices should dissipate as the economy improves and corporations manage through the bottom of the cycle.
Outright fraud is another story. While criminal behavior has yet to be proven against any of the corporate officers in question (despite a sensationalist and disquieting tendency on the part of the media to deem an individual guilty until adjudicated innocent) there is no doubt that many of the headlines about corporate skullduggery do not pass the smell test. It is also true that the U.S. has a history of treating white collar crime with a fine, a slap on the wrist and a six month stay in a government-funded guest facility.
The restoration of investor confidence will require much more. Whether or not more complete disclosure on the part of corporate managements and more scrupulous and independent analysis on the part of Wall Street will be sufficient remains to be seen. Jailing corporate criminals, once crime has been proved, for a serious amount of time will help restore confidence if it is perceived that the specter of such a fate is sufficient to deter corporate officers who might be contemplating similar behavior.
While all this plays out in corporate boardrooms, the media, Congress and the courts, the U.S. economy is steadily improving and corporate earnings are expected to produce their first upturn in six quarters when the third quarter is reported in October. U.S. Gross Domestic Product (“GDP”) for the first quarter of 2002 was recently revised upward to 6.1%, reminiscent of the “snapback effect” of more traditional recoveries when growth is high during the initial quarters after a downturn.
We do not, however, expect the economy to be a barn-burner despite the excellent first quarter. In fact, having never reached the extreme depths of downturn (such as those attained in 1973-74) we will probably only experience a modest upturn. Already, the economy is slowing after the first quarter surge, prompting skittish observers to warn about the potential for a “double-dip,” that is, an economy that initially generates stimulus-produced growth then slips back into a recession. We are not of this view.
A modest upturn is not necessarily a bad thing. In fact, steady if slower-paced economic growth augurs well for the sustainability of the recovery in that it slows the Fed from tightening monetary policy and moderates the potential for inflation. This is why we are not predicting a slip back into recession. In fact, the June Institute of Supply Management (“ISM”) Survey, an index of manufacturing activity, reached a new high of 56.2 and has expanded for the fifth consecutive month. An index number of 56.2 indicates a growing economy and is consistent with GDP growth of about 4.0% over time. Furthermore, the orders segment of the index remained above 60 as has been the case for four of the past five months. That 60 index number is consistent with industrial production growth of between 7 - 9%, which would represent an acceleration from production’s current 4.5% annual rate. Furthermore, the government’s index of leading economic indicators has rebounded, despite weakness in stock prices, indicating economic growth over the next six months.
As consumer spending slowed in the second quarter, double dippers came out of the woodwork citing the negative wealth effect created by a weak stock market and sliding consumer confidence as evidence that the consumer would eventually swamp the fledgling economic recovery. The facts, however, appear to belie these dire predictions. Personal income continues to rise and, so far, the positive effects of lower interest rates appear to have offset the negative wealth effect from flagging stock prices. Consumer confidence has probably been more affected by terrorist threats and evidence of corporate wrongdoing than by insecurity over employment and the economy.
If the consumer is the key to a continued recovery, the job market is the key to the consumer. Fortunately, the news on that score is also good. Wages continue to rise and modest job creation is underway with June payrolls up 36,000 following on to May payrolls, up 24,000. Retail chain store sales have rebounded sharply, setting the stage for a strong third quarter. Consequently, it appears that the consumer is still spending, albeit at a slower pace than is usual at this stage of a recovery. Fortunately, this slower pace is also positive as it reduces any tendency to ignite inflation, thus also potentially extending the duration of the recovery.
The real recession, of course, has been in capital spending but that is now beginning to turn up. Technology orders increased during every month of the second quarter. It is estimated that capital spending rose at about 8% in the second quarter, the best number turned in for two years. Furthermore, capital spending can be expected to accelerate in each of the last two quarters of the year as capital projects postponed during the earnings recession must soon be undertaken in order to take advantage in this tax year of recently enacted preferential tax treatment.
Government spending at the federal level is stimulative this year and net exports have recently improved, aided by recovering overseas economies and a weaker (but not collapsing) U.S. dollar. Consequently, we’re sticking with our GDP growth estimate for 2002 of 3.5% and continue to expect a 4.0% increase in GDP for 2003.
Inflation continues to be non-existent. The Consumer Price Index (“CPI”) is currently running at a rate consistent with approximately a 1.6% increase for this year. Lack of inflation and the stock market at five-year lows reduce pressure on the Fed to tighten interest rates. In fact, the futures market is predicting that there will be no Fed tightening at all this year.
The stock market has abandoned its traditional role as a leading indicator and is now completely disconnected from the economy. If there is no disconnect then the market is forecasting a deep recession and we don’t see this in any of the economic and corporate earnings data being released. The economy is fine, involved in a recovery that is modest but pervasive. Sooner or later, the market must resume its traditional role and begin to reflect the sanguine economic environment we envision ahead. At that point, a recovery in earnings growth will occur which could become the catalyst for a recovery in stocks.
