Taking Stock of the Equity Culture

Our new ideas about the market had already been challenged before Sept. 11. Now, risk is greater -- and so are the unknowns

By Bruce Nussbaum

It was the currency we paid our entrepreneurs, the way we financed our retirement, the means to corporate mergers, the measure of individual success, the game to win, the essence of our culture -- stocks. In the 1990s, the stock market defined America as never before. We lived in an equity culture in which we increasingly looked to the stock market to provide not only our immediate prosperity but also our social safety net -- once solely the responsibility of big government and big corporations. Now the foundation of this equity culture, the valuations of the stocks themselves, is being severely shaken.

With stocks plunging further in a week than anytime since the Depression, consumer net wealth dropping faster than anytime in history, profits falling at a record rate, and chief executives wondering if their current business models matter anymore, it is no wonder that we all feel so betrayed by the stock market. What has changed in so short a time?

In a word, risk. The soaring stock market of the past decade was based on a low-risk, high-certainty economy that made double-digit earnings growth rates possible as far as the eye could see. Lofty price-earnings ratios reflected a remarkable optimism about the future. After all, the U.S. had won the Cold War, and there was no serious foreign threat to its security. The homegrown high-tech revolution had left Japan and other competitors in the dust, tempered the business cycle, and opened new vistas for higher productivity and growth. Globalization expanded markets and sources of capital and labor. The federal budget went from deficit to huge surplus. Unemployment fears vanished as companies fought for employees. Cities recovered their vibrancy.


  Confidence was exceptionally high, and Americans were comfortable taking more chances in the stock market. Academics told them that the risk premium for stocks long term was no higher than bonds. So investors accepted sky-high p-e's, puffed-up bottom lines, and some strange business plans -- because who really knew what was possible? It was a time of opportunity, a time to place bets. And they paid off: A virtuous cycle of rising stocks, cheap capital, more investment, higher productivity, greater growth, and still higher equity prices generated enormous prosperity in the U.S., Asia, Europe, and around the globe.

Two assumptions turned out to be erroneous, however. The high-tech revolution did not eliminate business-cycle risk, as many had believed. As BusinessWeek pointed out in "The New Business Cycle", its March 31, 1997 cover story, technology made the cycle more volatile, not less. Over-investment in telecom and other tech industries led to a sudden and severe collapse in profits throughout the sector. Tech CEOs, who believed in their own control over the business cycle, went into shock. Chief executives who prided themselves on being able to see far into the future were forced to concede that they had "no visibility" for the quarter ahead.

Then, at this very point of economic weakness and vulnerability, the U.S. -- and the world -- became unsafe again. The attacks on the World Trade Center and the Pentagon made our lives uncertain and insecure. Geopolitics returned from the grave of the Cold War to trump globalization and challenge the open flow of goods, capital, and labor essential to the high growth and multiples of a buoyant stock market.


  That is where America and the world stands today. No one knows what stocks are worth just now. No one knows what valuation rules to apply. The new economics of uncertainty makes growth and earnings hard to forecast, and proper p-e ratios unknown. Only one thing is clear: The nature and size of risk have changed, and we are recalibrating them in everything we do. Most important, a political/military risk factor must now be incorporated into the economy's expected performance.

For the first time in decades, consumer confidence and business investment depend in large part on the execution of a complex international operation to destroy terrorism and make the country secure again. It could take months. It could take years. And no amount of patriotic talk can negate this uncertainty. That's why the stock market has lost its footing in recent weeks.

There are best-case and worst-case scenarios. The Bush Administration puts together an international antiterrorist coalition and eliminates Osama bin Laden rather quickly. The U.S. doesn't sustain any more terrorist attacks. Confidence returns. Big-government spending and low interest rates spur the economy, and growth returns by mid-2002 as the business cycle rights itself. The extra cost to the economy to secure the country remains modest. Higher military research and development spurs innovation. (The Internet, after all, is a child of the Cold War.) Earnings potential rises again, not to the halcyon levels of the '90s perhaps, but to a significant degree.


  The worst-case scenario is quagmire. The armed forces can't find bin Laden, or they do but then go after Saddam Hussein and get bogged down in a long war. Terrorists attack American cities, sapping consumer and business confidence. The cost to the economy to secure the country becomes heavy. Growth returns, but it is slow for years. Earnings growth shrinks to low single digits, and valuations tumble. The stock market languishes.

There are, of course, other scenarios. Both Britain and Israel have had vibrant economies and strong stock markets through years of terrorism. People can compartmentalize their lives and go on. There is even a possibility that the battle against terrorism could actually improve geopolitics -- tying Russia closer to the U.S., bringing Iran back to Western market democracy, opening statist Egypt to global markets. An end to terrorism would again raise investors' appetite for risk and raise growth prospects that support healthy p-e's. The stock market would flourish.

Which scenario plays out won't become clear until the mammoth U.S. effort to secure itself gathers momentum. At stake are the lives of many and the prosperity of all.

Nussbaum is Editorial Page Editor