A Recovery -- or Just a "Snapback"?


Much of the improvement in the economy -- and the market -- stems from a snapback from the shocks of September 11 rather than a new burst of steam, says William Wolman, senior contributing economics editor with BusinessWeek. He also gives much of the credit to the Federal Reserve's easing of interest rates and to Alan Greenspan, who Wolman describes as "the country's best unelected politician."

He expects overall growth to be below normal at least through the end of 2003. One of the main reasons for his forecast is that Wolman thinks capital investment in technology will continue to lag. As for the stock market, he takes the rather contrarian view that its performance has been mediocre -- essentially flat -- and he expects it to continue, with returns averaging only about 3% per year for some time to come.

These were among the points Wolman made in a chat on Mar. 19 presented by BusinessWeek Online and Standard & Poor's on America Online. He was responding to questions from the audience and Jack Dierdorff of BW Online. Edited excerpts follow. A full transcript is available from BW Online on AOL at keyword: BW Talk.

Q: Bill, is this recovery for real -- and how strong will it be?

A: It's clear that there has been an improvement in the level of economic activity, associated mainly with an end-of-inventory liquidation and the surprising strength of consumer spending on housing. I read this strength as mainly due to Federal Reserve easing in an unprecedented way.

However, I regard what has happened so far as mainly a post-September 11 snapback in the economy -- and I would take very seriously that part of today's statement by the Fed that says the strength of demand is still unclear. Business investment in high tech was the source of the great strength of the late '90s, and since there is no sign that this growth engine will continue to operate in the next couple of years, I continue to believe the economic growth rate will, on average, continue to be subnormal, at least to the end of 2003.

Q: How do you feel the retail sector will do in the coming months?

A: It seems to me that consumer spending has held up remarkably well, mainly because of easy Fed monetary policy.... There was a famous movie called As Good As It Gets, and I think that that applies to the numbers we've been seeing in the past couple of months, particularly those released last week. I am not forecasting a serious decline in either retail sales or housing, but I do believe that we will not see the kind of unexpected strength that characterized the post-September 11 rebound.

Q: Is there a specific reason why tax-exempt bonds have fallen in value over the past week -- and especially today?

A: There are signs that many states are having fiscal problems, which raises some questions about the security of interest payments. This may sound alarmist, and I hate to mention it, but the entire history of this country has been marked by defaults and suspensions of interest payments by state and local governments. I am not forecasting this outcome at this time. But the fact is that there can be questions about the creditworthiness of state and local issues.

Q: Do you believe small- or mid-caps will do best now?

A: It has been a good year for small- and mid-caps so far.... But I am not willing to say that in a difficult economic environment small- and mid-caps will continue to lead. One advantage of big companies, if I can be allowed to say so, is that they tend to have a certain amount of monopoly power. There is no way that this is a disadvantage.

In a global economy, bigness in the U.S. is not necessarily a limit on the growth of companies, since they can obviously grow abroad. I notice with interest, for example, that what is now the nation's largest company, Wal-Mart (WMT), has, according to its CEO, great expectations for growth in China, where it sees its business model working extremely well.

Q: The steep yield curve is a strong predictor of future gains in GDP, profits, and rising stock prices -- do you agree?

A: In general, the answer to that question is yes. However, I would stress that there are two factors at work here that limit the predictive power of the yield curve. One is simply that the Federal Reserve has been aggressively easing.... If that extraordinary easing ends, as it well may in the wake of today's Fed meeting, the yield curve may flatten some.

I'm very unpopular when I say this, but what surprises me in the wake of the Fed's aggressive easing is not how well the stock market has done, but how mediocre its performance has really been. The market is essentially flat for the year so far, despite the huge Fed easing. That's the kind of thing that prevents me from being really bullish.

Q: What's your view of the labor markets? When do you think companies will again begin hiring?

A: The labor market has behaved relatively positively in the past couple of months, given what has been going on with demand. I still think, however, that it will be tough slugging for the next few months at least.

What strikes me, and it's hard to exactly put numbers on it, is that this has not been a good year for people with good educations to get jobs, at least outside of health care and government. So I'm not sure that the aggregate data are telling the whole story.

Q: Do you think the economy is worse than the economic data show?

A: The answer for most Americans is I think it's a little worse. I believe that prices are rising faster than the data really show. There are two reasons why this is the case. The first is that the consumer price index is adjusted to reflect quality improvements. And the second is that the consumer price index is never adjusted to reflect quality deterioration.

Have you been on an airline recently, or were you on one before September 11? Clearly, the quality of service has declined as compared with where it was 5 or 10 years ago. Yet there is no adjustment in the price indexes.

Q: Should we invest? Should we select value stocks only? Should we seek income stocks? Or cash and bonds?

A: The answer that has stood the test of time is that it's very tough to pick stocks, or even sectors. That suggests that index funds should compose the largest part of your portfolio, particularly the funds run by Vanguard and TIAA-CREF, which now has funds that are open to the general public.

My own particular instinct is to look to Europe as an interesting place to invest, simply because, as Alan Greenspan pointed out in a speech last week, the U.S. trade deficit will have consequences. I do not foresee a strong dollar.

One other point: The U.S. is bearing most of the cost of the war on terror, and that brings with it the probability that U.S. spending abroad for defense will rise. If we look at the past, accelerated defense spending has not been good for the dollar. It was not good in the Vietnam War, it was not good earlier than that in the Korean War, it was not good in the early '80s in the Reagan defense buildup, and it will not be good again.

I take this point seriously, and it makes me relatively bullish on the stock markets in the other advanced industrial countries, especially in Europe.

Q: When do you think tech will return to "normal" growth?

A: I do see slower growth for tech over the next few years than the fabulous growth rates of the late 1990s. There is not a catastrophe in store here, but I do believe that economic growth for the U.S. as a whole will be disappointing because the growth in capital investment in technology will continue to be restrained.

It's very clear that biotech will be a huge growth engine for the U.S. at some point, but the biotech growth curve is still in the slow-growth stage, and it will be several years before biotech spending gets big enough to have a major impact on the economy as a whole.

Q: Will the war on terrorism cause inflation like the Vietnam War did?

A: The scale of spending is not as large, but if the question is, "Will the war on terror cause inflation," the answer is yes. There are two basic reasons. One is that it will raise business costs, which I think is obvious. And the other is that it will add to the federal deficit.

I do not by any means think that inflation is a problem of the past. The two fastest-growing sectors of the American economy -- health care and education -- are inherently inflationary industries. So I believe that inflation will be a problem -- particularly to the middle class, for which education expenses are so important.

Q: Put on your forecasting cap, Bill. What percentage increase or decrease do you see in the Nasdaq this year?

A: Let me just give you a number: I think the Nasdaq will end the year at 2000. The Dow ends the year at 11,000.

Q: Do you think the stimulus bill that finally came out of Congress will do anything to speed up the slow comeback you see?

A: Yes, to some extent it will. I think expensing of capital equipment over a three-year period will make a difference. And I also think the extension of unemployment benefits was needed -- and a humane thing to do, although I'm not convinced it will have much stimulative impact. But the expensing provisions will provide some punch.

Q: What do you think of Bush's economic policies vs. Clinton's?

A: To a large extent, it's Tweedledum and Tweedledee. I regard the cuts in marginal tax rates that are programmed for the out years as being very much a subject of further legislation.... I also would like to say what has not been said so often in the past, that Fed policy in the past couple of years has been extraordinarily effective, for which both parties deserve some credit for keeping their hands off and for which Greenspan deserves great credit for being the country's best unelected politician.

Q: Will our huge and growing current-accounts deficit have any impact on our economy?

A: The answer to that question is yes. Countries that run large current-accounts deficits, as Greenspan pointed out last week, inevitably run into trouble. I am not forecasting any crisis in this area -- the U.S. is simply too powerful -- but the trade deficits will cause interest rates to be higher than they would otherwise be.

Q: Can you predict out this far? Give me your estimate of what the market should return in the next five years (in percentage terms).

A: If I can do some self-promotion, I have co-authored a book called The Great 401(k) Hoax, which our publisher tells me will be in the bookstores on May 7. In that, I forecast a real rate of return to investing in stocks of about 3% per year over the next decade.

That means I believe that the breaking of the stock market bubble in 2000 and 2001 will have negative implications for the market for at least a decade, just as the breaking of bubbles in 1901, 1929, and 1966 did. Price-earnings ratios were driven higher in 2000 than in any of those three preceding bubbles, and p-es are still at extreme levels in today's stock market.

I therefore expect relatively slow growth in stock prices over a sustained period of time. This is one case where I'd love to be wrong, but relatively flat markets are my expectation. I would like to point out again, as I did when this chat started, that what's surprising about the market this year is not how well it's done, but how mediocre its performance has been -- and I expect that to continue.


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