The current mood of investors is much worse. In recent weeks, news on the economy--and its forward-looking implications for continuing growth and rebounding profits--has been uniformly excellent. But on June 3, for example, when a report on industrial activity, usually a market-mover, showed surprisingly strong growth in May, stock prices sank to lows not seen since just after September 11. Investors seemed more concerned about the corporate soap opera at the conglomerate Tyco International Ltd.
What's out of whack here is that investors seem to have forgotten that stock prices embody economic prospects, a fact that traditionally has made them a foreshadowing indicator of the economy. Right now, investors are behaving as if there is no recovery and as if an upturn in profits is nowhere on the radar screen--even while the evidence to the contrary is smack in their faces.
Consider the latest data. In May, consumer confidence rose to levels not seen since before the recession officially began. Car sales, while down from April, are still running slightly ahead of their first-quarter pace. Mortgage applications to buy a home hit a record in late May, and are also above their first-quarter level.
Moreover, consumer demand is invigorating the industrial sector. The nation's supply managers said that in May, rising orders were boosting industrial output and pricing power (chart). The report followed April news that factory orders rose more than expected, including a big jump in capital goods orders. And productivity data show that companies are cutting costs drastically and shoring up profit margins without inflicting the usual pain on workers' buying power.DESPITE ALL THIS UPBEAT NEWS on the recovery, investors seem more concerned that something is rotten in Corporate America and that it is distorting the true picture of profitability. To be sure, uncertainties run high in this recovery, including threats of terrorism, Middle East conflict, war between India and Pakistan, an eroding fiscal balance at home, and now the dollar. But with market sentiment as poor as it is now, these worries are bound to be magnified.
The dip in the dollar is the latest fear. Investors worry that foreigners will begin to abandon U.S. investments for more attractive bets elsewhere in the world. However, keep the greenback's slippage in perspective. Its price-adjusted, trade-weighted value against a basket of major currencies through the end of May is down 3.8% from its February peak. However, that level was 39% above the dollar's average level during the first half of the 1990s--and a zenith at which the greenback was widely believed to be overvalued by most measures (chart). In the year ended Feb. 28, the dollar even managed to gain 7.3%, an unusual pattern during a recession.SOME DEGREE OF ORDERLY DECLINE in the dollar is likely to be more salutary than harmful. It will help to boost exports as global markets recover, and it will even lift profits of U.S. multinationals, as those earnings are translated back into dollars. It will also give U.S. manufacturers a little more pricing power.
The flip side of the dollar's downward adjustment--mainly, heightened inflation pressures--would come into play only if the drop were rapid and sizable, reflecting a crumbling of faith in the U.S. economy. That seems highly unlikely, as the recovery continues to take shape, and especially as exceptional productivity growth signals that long-run prospects for U.S. economic growth and profitability are the most favorable in the world.
Indeed, the recovery is on increasingly solid ground. Even the manufacturing sector, which had suffered its steepest recession since World War II, is getting pulled along. The Institute for Supply Management's index of industrial activity rose from 53.9% in April to 55.7% in May. The index set a high for this recovery, and the gains were broad across industrial sectors. In the past, a reading at that level, if maintained, has been consistent with overall economic growth of at least 4%.
The details of the ISM survey of companies are especially encouraging for future growth. The ISM's orders index shows orders are growing at a rate last seen in 1999, when the economy was strong. Orders are being driven in part by a rapidly dwindling level of inventory. The group's index of customer inventories, a measure of the adequacy of current stockpiles, fell in May to the lowest level since the ISM began tracking it in late 1996. That will provide an impetus for further gains in orders and production in the third quarter.
Also, the companies in the survey report that markets are tightening up. Delivery times in May were the longest since early 2000, and the ISM's price index rose further, indicating that past price hikes are sticking. The combination of increased output and more pricing power is a good sign that top-line revenue growth is beginning to pick up this quarter, and that pattern should continue this summer.THE PLUS HERE is that, with productivity growth so strong and unit costs falling so sharply, any revenue gains will go straight to the bottom line. New data on nonfinancial corporations, a sector that produces a more accurate measure of productivity, show that over the past year, productivity rose by a robust 5.5%, while the labor cost of producing a single unit of output fell 0.9%. This means that while prices in the sector increased only 0.2%, companies were still able to earn more on each unit they produced and sold.
But the remarkable story of this business cycle is that, at the same time, the inflation-adjusted compensation of nonfinancial corporate workers is still growing at a healthy 3.2% from a year ago (chart). In the past, in order for companies to slash unit costs as much as they have in the past year, laborers have typically suffered greatly, often deepening and lengthening a recession. The productivity-driven improvement in both profits and consumer buying power is the key force behind this economic recovery.
Fed Chairman Alan Greenspan was unusually clear on this point at an International Monetary Fund conference in Montreal on June 4. He said, "something fundamental is going on in our system which has remarkably improved underlying productivity growth in our economy, and that is going to be a materially positive factor for growth."
Of course, investors still don't see it that way. But they will. Eventually, the good news on economic prospects will be bracing enough to strengthen the backbone of even the most discouraged investor. By James C. Cooper & Kathleen Madigan