What's Driving the Market?


To look at Wall Street, you'd think it was in denial. A mere six weeks after the market reopened in the wake of the September 11 terrorist attacks, all three major indexes are flirting with their Sept. 10 trading levels. In the meantime, corporate earnings have taken a nosedive (see BW, 10/26/01, "Now, Profits Are In Free Fall").

While nimble CEOs jumped to prepare investors for the poor results for the quarter ended Sept. 30, they're also saying the fourth quarter will be as bad if not worse. "Analysts are aggressively revising fourth-quarter earnings expectations downward," observes Charlie Reinhard, senior strategist at Lehman Brothers. "Shortly after the September 11 attack, the expectation was for a drop of 4% in fourth-quarter earnings for the S&P 500. As of [Oct. 19], the consensus estimate had been revised to a 13% drop." Now, Lehman's research team anticipates a 27% drop in fourth-quarter earnings year-over-year -- the deepest quarterly drop since 1951, according to Reinhard.

LOOKING AHEAD. So why is the market buoyant? It sees a real possibility of economic recovery in the second half of 2002 -- and looking ahead that far is normal when the market is assessing value (see BW, 10/26/01, "Capitalism's 'Animal Spirits' Endure"). Corporations are continuing to cut expenses, so when revenues rebound -- probably in the second quarter of 2002 -- profit margins will get the full benefit.

At the same time, bulls point to an aggressive Federal Reserve easing policy that has made cash-hoarding a negative real return. Add to that a resilient housing market, still-rising wages, and fiscal stimulus in the form of tax cuts, and you've got enough positives to offset the negatives of poor earnings and layoffs -- and to keep the consumer at the shopping mall.

This might seem counterintuitive, given the job cuts that have occurred since September 11 and are likely to continue at a level that would bring unemployment up to 6% or higher. But at the same time, wages are climbing. Despite the layoffs, Milton Ezrati, senior economist and strategist at Jersey City-based fund manager Lord, Abbett, points out that "Wages and salaries have risen 4% the past year, which means the consumer has been able to pull in his horns a bit without stopping spending altogether."

CASHING IN. So far, Fed policy has helped by creating liquidity that has kept housing prices up. "If we do have a recession, it will be unusual in that housing prices never broke," says Christine Callies, chief strategist at Merrill Lynch. Record numbers of consumers are using the increased value of their homes to improve their cash situation. "The employed segment of the population is taking advantage of lower rates," she says. That's why consumer spending will probably turn up even though the economy is in recession, she adds.

The fact that cash is plentiful isn't the only reason spending will increase. The real level of interest rates will force consumers to either buy goods or stocks within the next month or so to maximize their income, according to Lehman's Reinhard. With the Fed's short-term target rate at 2.5%, money-market rates have fallen to around 2.8%. That's an aftertax return on cash of less than 2%, well below the 2.6% inflation rate of the core consumer price index (CPI). "If you hoard cash, you actually decrease your standard of living," says Reinhard. "The consumer can bear that for a couple of months, but not much longer."

Consumers figure out that it makes more sense to invest in goods that improve living standards -- or to put the money in the stock market, where investment returns can beat inflation. Usually, the consumer shifts cash into a little of both. Small wonder that retailers and the auto industry have used advantageous promotions to coax some cash their way.

WAITING FOR A FLOOD. At the same time, current stock prices are anticipating a flood of investment from the $2 trillion currently parked in money-market funds, especially if the Fed continues to cut rates. Policymakers meet on Nov. 13 and are widely expected to cut rates a quarter point, if not a half. That added stimulus could spark an equity rally, which would in turn could push price-earnings ratios above current levels -- about 20 times for the Standard & Poor's 500 -- which many analysts say is about fair value.

Bears obviously disagree, fearing p-e ratios that high must be inflated. But Merrill's Callies isn't worried. "The time to worry about high p-es is after a couple of years of strong earnings growth, because that assumes that high earnings growth is [indefinitely] sustainable," she says.

It's true that corporations are expected to experience a classic margin squeeze as revenues drop off faster than expenses. Still, this effect shouldn't be overwhelming. A recent National Association of Business Economists (NABE) survey shows that two-thirds of CEOs believe the revenue drop that occurred in the weeks directly after September 11 will have a minor overall impact on their businesses.

CUTTING COSTS. Even though wages are going up, "the net rising [wage] index is at the lowest level it has been in the 20 years we've done the survey," says Harvey Rosenblum, NABE president and director of economic research at the Federal Reserve Bank of Dallas. That means companies are whittling down their cost bases accordingly, which could yield an earnings rebound as early as the second quarter of 2002. "The economy probably entered recession in the third quarter, which makes the fourth quarter a write-off," adds Rosenblum.

Of course, all bets are off if another terrorist attack with the impact of September 11 occurs. But barring outside shocks to the economy, it looks as though consumer spending, which has held up thus far into the slowdown, will continue. Even though it won't pull December earnings out of the trough, it'll help them in 2002. By Margaret Popper in New York


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