Commentary: Hey, Chicken Littles, the Sky Isn't Falling

Bear market? Recession? Snap out of it! True, the stock market looks ill, and the economy is soft. But the imbalances that threaten the U.S. expansion are quickly righting themselves. Nor is that healing likely to stop, given the rapid and strong support of the Federal Reserve. The economy is suffering a temporary bout of indigestion, not a recession.

Ultimately, the drop in stock prices is not so much a bear market as it is a return to more sensible valuations. And with the price-earnings ratio of the Standard & Poor's 500-stock index down and bond yields falling, the air is almost gone from the bubble. "If equity prices are not fairly valued, then they are close to it," says economist Mark M. Zandi at in West Chester, Pa.

FAIRER P-Es. Indeed, despite investors' fears that p-e ratios remain too high, that is no longer the case when they are compared with the inverse of bond yields--a classic valuation model used to determine the so-called fair-market value of stocks. Under this method, fair value is the level that equates the returns on stocks and bonds. Based on the current 5% yield on a 10-year Treasury, the fair-market p-e ratio is about 20. The actual p-e for the average S&P 500 company is about 21 today, using expected earnings per share for the next 12 months.

Certainly, earnings expectations may still be too high--especially in the technology sector, where the typical stock changes hands at a p-e of about 32. But they have made an enormous downward adjustment in the past six months, and nontech valuations look increasingly attractive.

The biggest worry in the market is that prolonged stagnation or an outright recession could deepen earnings woes. Such fears are overblown. While the economy's weakness is genuine, it is neither broad nor deep. While gross domestic product in the goods-producing sector fell at a 2.8% annual rate last quarter, GDP in the service sector, which employs three-fourths of all workers, grew 3.8%.

For all the uncertainty, the slowdown isn't really all that mystifying. It's the result of past Fed tightening and the bursting of the stock market bubble. That concentrated the economy's weakness in demand for big-ticket durable goods, especially autos, an area that had soared on the hot air of low rates and the market's wealth effect.

What's new about this slowdown is its speed, which is making people nervous and fearful about the future. Today's rapid flow of information has fast-forwarded needed adjustments in output, payrolls, capital spending, and inventories. But that's good. "The faster any imbalances are cleared out, the sooner the economy can resume a faster pace of growth," says Bruce Steinberg, chief economist at Merrill Lynch & Co.

Inventories are a perfect example. Merrill Lynch economists show that inventory imbalances now require an average of two quarters to eliminate, vs. about five prior to the 1990s. Indeed, inventory growth in December was far less than expected, suggesting that a full correction may be over by midyear.

Stalwart consumers are helping to speed the inventory realignment, and they will put a floor under the weakness in capital spending. As Fed Chairman Alan Greenspan noted on Feb. 28, the rapid drop in consumer confidence "has not been matched by a concurrent decline in consumer expenditures." Consumers relieved retailers of excess Christmas stocks with strong January buying, and consumer fundamentals are supportive: Labor markets are still tight. Oil prices are below $28 per barrel, and wages are outpacing inflation. Without a full-blown consumer retrenchment, demand for final products will be firm enough to shore up profits and limit damage to capital spending.

ANOTHER CUT. Recently, investors seemed worried that the large gains in the January price indexes would hamstring the Fed. That's wrong on two counts. First, inflation always trails the business cycle, and it should end the year lower. Second, since the Fed is fighting perceptions of economic weakness as much as economic reality, it will likely buoy sentiment with another half-point rate cut at its Mar. 20 meeting.

Above all, remember the old saying: Don't fight the Fed. Every time since 1950 that the Fed has cut rates, the market has rallied, on average, with a 20% annualized advance, say analysts at Prudential Securities Inc. That may not be possible this time after such inflated valuations. But both the economy and the market are likely to finish the year in much better shape than they started it.

By James C. Cooper

Cooper writes BusinessWeek

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