Finding Your Bearings in the Turmoil


By Amey Stone and David Shook Fragile is probably the best word to describe the U.S. economy right now. For the next few days, if not weeks, stocks are likely to trade on military news related to U.S. attacks on Afghanistan and, dare we even mention it, any potential new response from terrorists (see BW Online, 10/9/2001,

"How Will Wall Street Define Victory?").

Investors, however, should keep in mind that trading around military action may ultimately have precious little to do with what really drives stock prices -- corporate earnings. The terrorism and America's response "add noise and uncertainty to the market," says Michael Ingraham, director of research at U.S. Global Investors. But the most important factor driving stock prices is what he terms "a very serious profits recession."

What will get corporate profits growing again is strength in the U.S. economy. Despite levels of national unease about the future that the U.S. hasn't experienced since World War II, there is plenty of reason for optimism.

ALREADY STARTED? While economists and market strategists ponder how deep the recession will be and whether the rebound will come early or later, they almost all agree that growth will resume next year. In fact, many bullish investors believe the market has already started its rally in anticipation of an economic recovery in about six months. For the bulls, drags on the economy are just delaying the ultimate rebound.

Not everyone is so sanguine, however. Plenty more bad news is yet to come concerning the economy and corporate profits before any firm signs of a recovery show up. For bears like Edward Yardeni, Deutsche Banc Alex. Brown's chief investment strategist, all the boosts to the economy are just "important offsets to what otherwise might have been much worse."

What to expect? Here are some factors for investors to consider as they survey this fragile economy:

The Pluses

Interest rate cuts: The amount the Federal Reserve has cut short-term interest rates -- nine times since the beginning of the year -- is unprecedented in recent history. "We haven't seen rates this low in 40 years," says Mark Zandi, chief economist at economic consulting firm Economy.com. The Fed has cut short-term rates from 6% to 2.5% and is expected to keep cutting. Many market strategists say such massive easing of monetary policy has always been bullish for stocks. They don't care much if it takes a bit longer this time around for the benefits of the rate cuts to take hold.

Fiscal stimulus: No one could accuse the Bush Administration of cooling its heels these days. Along with $55 billion in emergency spending, the Bushies are now proposing tax relief of $60 billion to $75 billion. Merrill Lynch expects fiscal stimulus to total about $150 billion, or 1.5% of gross domestic product.

Basically, the Administration has shown willingness to do anything and everything it can to get the economy going. Policy wonks will debate which tax cuts will get the economy moving the fastest and wring their hands over the long-term ramifications on the federal budget, but most observers agree that the economy will get a much needed boost.

Lower energy prices: Consumers are already benefiting from lower costs of gasoline and home heating oil. Because Afghanistan produces little oil, CIBC World Markets analyst Van Levy does not expect a spike in crude oil prices, which have dropped 27% from a year ago to a current price of $23 a barrel. He also believes natural gas prices could decline. Soft prices certainly aren't good news for energy stocks, but they do lower costs for consumers and businesses, putting more money in pockets and fueling the economy.

Cash on the sidelines: With the stock market sliding for 18 months and bond yields decidedly unappetizing, investors of all stripes have plenty of cash ready to put to work in the stock market once clear signs of an economic recovery appear. Assets invested in money market funds now total $2.23 trillion, according to the Investment Company Institute. And that's not even counting all the cash in stock mutual-fund portfolios (see BW Online, 10/08/01, "Hoarding Cash in Times of Trouble").

The Minuses

Consumer spending. Buoyant consumer spending has kept the economy afloat most of this year. But consumers went into hiding after the September 11 terrorist attacks, and although some signs show that shopping has picked up, that may be only because retailers are offering such steep discounts. "Retailers are giving their profits away in order to move merchandise," says Yardeni. He points to a rising personal savings rate as the clearest indicator that consumers have finally been spooked into packing cash away for a rainy day. That's may be a good move for family finances, but it's not great for the economy.

Corporate profits: The U.S. was already in corporate-profits recession, and the September 11 attacks have only made it worse. The pain has thus far been sharpest in the tech sector, where spending has all but dried up. But consumer cyclicals (auto makers, retailers, home-furnishing companies) may have the most pain yet to come. In an Oct. 8 note to clients, Prudential analyst Stacy Pak again warned that her outlook for holiday sales was worsening and said she may cut earnings estimates on the retailers she follows.

Investors are going to get barraged with third-quarter earnings reports in the next week, and "we'll see lot of bad news," says Chuck Hill, director of research at First Call. As profits fall, companies eager to cut costs will lay off more workers, which will dampen consumer confidence -- not an easy cycle to break. Hill believes the earliest corporate profits will turn up is the second half of next year.

Valuations. Believe it or not, stocks are still quite expensive relative to earnings. The S&P 500 has a price to earnings ratio of 21 on 2002 earnings, but many stocks are trading at p-e's of 30, 40, or 50 times next year's earnings, says Ingraham. "That kind of discrepancy when there is no earnings growth is not supportable," he warns. Yardeni believes this could limit any additional upside when the economy and corporate profits show signs of a rebound.

Global ties. Now the three major world economies are all weakening, with Japan in far worse shape than the U.S. and Europe faring a bit better. "We have to look over our shoulder to make sure these things don't get interlocked to the point where we see a downward spiral," says Hill. Yardeni says he's already worried about falling industrial commodity prices, including the above-mentioned drop in oil, which indicates that global economic activity is slowing.

The bottom line is that the U.S. economy will eventually recover, but if it has to fight its way out of a global synchronized recession, it might take a while. Stone and Shook cover the markets for BusinessWeek Online in New York City


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