By Christopher Farrell
Are investors irrationally exuberant? It sure seems so. The destruction of September 11. War in Afghanistan. The economy in recession. Soaring layoff announcements. The terror of anthrax through the mail. The threat of other, more terrible biological weapons. Yet the Dow Jones industrial average, the Standard & Poor's 500-stock index, and the Nasdaq composite index are all above where they were the day before the horrific terrorist attack on America.
Investors aren't suffering from delusion, a speculative frenzy, false consciousness, or some other distressing form of mass mania. Yes, an unforeseen event or tragedy can change investors' calculus. But barring a U.S. military disaster abroad or an even more vicious terrorist assault at home, investors are assigning a reasonable probability on the economy's prospects in the coming years, not just the next six months or so.
WELLSPRINGS OF GROWTH.
The stock market may be signaling that Americans haven't lost their appetite for longer-term risk-taking, although investors did abandon it just after September 11. Witness the plunge in the stock market when the New York Stock Exchange finally reopened. "The spike in perceived risk generated a risk premium, in the form of those plunging prices of mid-September, that apparently proved irresistible to risk-takers who still had money to invest," says Jim Griffin, chief investment strategist at Aeltus Investment Management.
The wellsprings of economic growth aren't just technology, globalization, investment, or even productivity. It also includes risk-taking, what economist John Maynard Keynes called "the animal spirits of capitalism." Everything else pales in comparison to the entrepreneur, corporate manager, investor, and worker taking risks.
In mid-October, I spent two days in Austin, Tex., talking to casualties of the dot-com bust. Spirits remained high, and I didn't come across any evidence that people were adopting the potentially catastrophic mindset of survive at all costs. What I did find is less nervousness over the decline in the stock market.
Perhaps the 22% drop in the market over the past year just fades in significance when compared with losing loved ones, as happened in New York, Washington, and elsewhere. "Is your life really worse if your portfolio is off by 20%?" asks Meir Statman, finance professor at Santa Clara University. "I hope that [the terrorist attack] puts life and risk and what we are all about into perspective."
Wall Street experts are fond of saying that markets operate on fear and greed. That cliché has a shade of truth, but only in the short run. Yes, the Dow, S&P 500, and Nasdaq fell sharply when the market reopened after the terrorist assault. However, the stock market is much more of a calculating machine weighing the cost-benefit odds than the sufferer of bipolar disorder.
The market is a global trading institution that lets investors discuss all kinds of information, data, analysis, gossip, and rumor. The conversation and trading involves just about everyone in the economy and markets, including corporate managers, economists, money managers, stock pickers, speculators, and academics. It's during these never-ending conversations that information and rumor is transformed into knowledge and judgment. That's why economic and corporate fundamentals eventually prevail.
Investors are placing a bet that the recession (assuming the country is now in one) will be followed by a recovery sometime early in 2002, despite the drag from anemic corporate profits and higher unemployment. The Federal Reserve had already eased rates seven times this year before aggressively responding to September 11. Lower interest rates could save consumers up to $70 billion in interest payments in 2002, and cheaper energy may mean another $70 billion, according to economists at Merrill Lynch. Tax cuts could put yet another $70 billion or more into consumers' pockets, depending on the eventual fiscal stimulus package from Congress.
The bear market in stocks is probably close to over, too. Wall Street typically recovers six months before the economy does. To be sure, the market isn't cheap by many historic measures, including price-earnings ratios. But valuations are more attractive now than they were at the beginning of 2000.
The historic evidence going back to 1950 is that the p-e ratio tends to be high when interest rates and inflation are low. Bear markets have typically bottomed out when p-es have dropped 30% to 50% -- and the 30% threshold was reached in late September. Time is on the equity investors' side, although it's doubtful that stock market returns will climb back to the double-digit performance of the late 1990s. That was a once-in-a-lifetime feat.
There's a lot to worry about concerning the long-term health of the U.S. economy, especially the deadweight costs of heightened security. But the market seems to be saying that the economy's potential is much higher than the pessimists suspect and the optimists hope for.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online
Edited by Beth Belton