The Street's Recession Fears

Most economists say an economic downturn in the U.S. is unlikely, but the stock market looks very worried

by Ben Steverman

Take a look at recent economic data and talk to leading economists, and things don't look so bad. The main debate is over how fast or slow the economy will grow, not whether it will shrink.

But then look at the stock market: Investors are very worried.

Share prices, which often act as an early warning system, seem to expect a U.S. recession starting in late 2007, according to David Bianco, a strategist at UBS Securities (UBS). Such a recession, if it occurs, could last through most of 2008 and slash profits of Standard & Poor's 500-stock index companies by 10%, Bianco says.

He bases his prediction on an analysis of the price-earnings ratios of S&P 500 stocks after the recent stock market sell-off. Some parts of the stock market are holding up well, especially those profiting from the global economic boom. Feeling the pain are sectors that get much of their earnings from the U.S., especially financial stocks. The market seems to expect "tremendous declines" in the earnings power of big banks and brokerage houses, Bianco says. "The market every once in a while puts up a red flag, and this is what it's doing," he says.

Hint of a Credit Crunch

The main worry is a credit crunch, the possibility that worries about defaults on subprime mortgages are spreading to various other kinds of debt. That concern began in the credit markets and spread to the stock market in late July, causing major indexes to plunge. If a tightening of credit occurs, it could be disastrous for the U.S. economy, says Rob Brown, chief investment officer at Genworth Financial Asset Management (GNW). "If [borrowers] pull back hard enough, that's all it takes for a recession," he says.

But so far, only the barest inkling of a credit crunch is showing up in actual economic data, Brown adds. "We're talking about behavior that has yet to occur," he says. And so Wall Street waits. Yet in the meantime, the Dow Jones industrials tumbled again last week and are down about 6% for the year—more than 800 points from a July 19 record closing high above 14,000 and just 4% shy of correction territory.

Markets are good at adjusting to good or bad information, Stephen Wood of Russell Investment Group notes, but markets aren't so good at uncertainty. "That is rattling stocks," he says.

Plenty of Good News

It's worrying stock investors despite plenty of signs the economy is in good, if not great, shape. "The risk here is that we talk ourselves into getting into a slump we're not in," says Brian Gendreau of ING Investment Management (ING).

Here's the good news: Weak economic growth in the first quarter of 2007 was followed by a solid rebound in the second quarter, at least according to initial figures. The job market is healthy, even if the unemployment rate ticked up to 4.6% in July, from 4.5% in June.

Corporate earnings in the second quarter have beaten analysts' expectations. With second-quarter earnings season mostly over, S&P 500 earnings beat estimates by more than 4%, according to Reuters Estimates (RTRSY). More than two-thirds of companies beat estimates, while only about 19% missed. The bad news comes from the automotive and housing sectors. Excluding those, "the rest of the economy has been growing at a healthy rate," says Michele Gambera of Ibbotson Associates, a subsidiary of Morningstar (MORN).

Still Too Early to Tell

However, there are plenty of reasons for economists to argue and scratch their heads. Though Gambera thinks a recession is the least likely outcome, he adds: "What I see is a lot of conflicting signs."

Will consumer spending slow down? How bad will housing get? What's going on with inflation and business investment? Finally, how bad will the so-called credit crunch get? That last question could take months to play out.

Remember Bianco, the UBS strategist who believes the stock market is priced for a recession? He's not so sure himself. "We agree the economy's slowing," he says. "We agree there are credit concerns out there. We just don't think it's going to be that bad."

Classic Battle: Bulls vs. Bears

This happens all the time, he says: The stock market, ever peering months into the future, gets spooked only to settle back to normal when the threat fails to arrive. "The market doesn't always get this right," Bianco says.

On Wall Street, all this uncertainty creates a classic battle between bears and bulls. "You've got two strongly opposing views with a lot of money behind them," says Brian Reynolds, chief market strategist at M.S. Howells & Co. Deciding the contest will be evidence of what's actually going on. Will threats to the broader economy, now mostly hypothetical, materialize in the data?

A mixed bag of economic data last week didn't help, according to Joseph LaVorgna, Deutsche Bank's (DB) chief U.S. economist. "While it is too soon to quantify the effects of the recent financial market tightening on the economy, the first place that it is likely to show up is consumer confidence," he wrote Aug. 2. So, keep an eye on the preliminary reading for August consumer sentiment, expected Aug. 17.

Until a trend is clear, expect the market to continue to swing wildly as investors place bets on their fears, real or imagined, of a U.S. recession.

Steverman is a reporter for BusinessWeek's Investing channel.