Commentary: The Case for Optimism
By Michael J. Mandel
For more than two years, the stock market has been on a downward slide. Since the Standard & Poor's 500-stock index peaked in March, 2000, it has lost more than 40% of its value, with the drop seemingly accelerating. Another month like the last one will make this the deepest market plunge since the Great Depression.
It's only natural, then, that investors are scared that the rest of the year will bring more of the same. Their worries are fed by skepticism about corporate accounting and earnings, anger at executive greed, and doubts about the economic recovery's strength. Add in fears about more terrorist acts, and it seems as if there is no bottom in sight.
Despite these concerns, there's a good chance that both the stock market and the economy are poised to stage a stronger-than-expected recovery in the coming months. For one, corporate profits could be surprisingly robust. Slowing wage growth is finally enabling companies to boost their bottom line, although it may not be immediately evident amid the blizzard of earnings restatements and accounting changes.
And the tech sector may be on the verge of a rebound, the latest round of layoffs announced by Intel Corp. on July 16 notwithstanding. The excess capital spending of the 1990s appears largely to have been worked off, as Federal Reserve Chairman Alan Greenspan noted in his testimony to Congress that same day. Moreover, higher profits will make corporate buyers more willing to spend. Additionally, low interest rates mean that plenty of liquidity is available to fuel a market rally.
Of course, potential pitfalls lie ahead. The two biggest: more terrorist attacks and the discovery of major accounting fraud at another company outside of telecom or utilities. Either one could keep the market from recovering anytime soon.
But more grounds exist for optimism than angry investors realize. Remember that over the last 10 years, the U.S. stock market and economy have shown a great propensity for unexpected swings, both up and down. In 1996, for example, Americans were anxious about the future, as companies kept laying off workers. A February, 1996, BusinessWeek/Harris poll showed that 86% of Americans were concerned by the possibility of a slowdown in economic growth, and 56% were worried about another stock market crash. Instead, what followed was one of the biggest booms in history. Similarly, as the country approached the peak of the stock market bubble in December 1999, most analysts were still optimistic about the market's prospects, expecting a gain of 10% in the S&P 500 in 2000, according to a BusinessWeek survey.
Here's why the economy and the markets may be ready to make yet another U-turn. Start with corporate profits. Peering beneath the accounting tricks, the underlying profit margins of most corporations really depend on two factors--worker productivity and wages. The ideal combination for corporate profits is high productivity growth plus slow wage growth.
That's exactly what we're heading for. Productivity seems to be rising at a solid 2.5% to 3% rate, with more data to come when the Commerce Dept. releases second quarter growth figures on July 31. Meanwhile, wage growth is slowing sharply, as companies cut back on pay. In the second half of 2001, average hourly earnings rose at a 3.8% rate. The latest figures show wage growth down to a 2.8% rate in the first half of 2002, and likely to fall further, as long as unemployment stays around 6%.
This slowdown in wage growth has an enormous impact on profits, because payments to labor are about eight times as large as pretax earnings. As a result, a one-percentage-point decrease in wage growth, all other things being equal, translates into an additional eight percentage points in earnings growth. The early second-quarter profit reports already are reflecting these gains, as companies such as Nextel Communications (NXTL ), Merrill Lynch (MER ), and General Motors (GM ) announced results that beat expectations.
If profits continue to rise, the technology sector will be one of the big beneficiaries. Since late 2000, business spending on computers, communications gear, and software has been depressed, driven down by a combination of excess spending in the boom years and low corporate profits.
But after two years of the worst tech downturn ever, corporations have cut technology spending so much so that they have reduced or even eliminated the overhang of equipment and software. According to calculations by BusinessWeek, from 1995 to 2000, companies overspent on technology by about $100 billion, as such outlays far outpaced the long-term growth trend of 12% a year. Since then, corporate tech spending has plummeted, dropping as much as 20% below what the long-term trend would imply.
This suggests that once corporate profitability begins to head up, information technology managers will want to open up the spending spigots. Indeed, if they underspent their budgets during the first half of 2002, they may have to accelerate outlays toward the end of the year, which would create a big pop.
Already there are signs of a tech revival. According to the latest data from the Federal Reserve, production in the technology sector rose by 6% from March to June, compared with only a 1% gain in the rest of manufacturing. Capacity utilization, too, is on the rise among tech companies.
The job cuts at Intel (INTC ) do not necessarily signal bad news. For one, other technology companies, such as Motorola (MOT ), are forecasting higher sales in the second half. Moreover, labor force reductions in the sector can often lag the worst of the downturn, as do job reductions in other parts of the economy. In 1996, as the greatest tech and telecom boom in history was gathering momentum, companies such as Texas Instruments (TXN ), Apple Computer (AAPL ), Motorola, and IBM (IBM ) were still trying to reduce costs by laying off or buying out tens of thousands of workers.
The final force working in favor of a strong rebound is the Fed's low interest policy. The Fed funds rate, at 1.75% since December 2001, is well below inflation. That makes borrowing extraordinarily cheap and means a lot of money is ready to move into the stock market when and if share prices start to rise. Moreover, the low rates innoculate banks, Wall Street investment banks, insurance companies, and other financial institutions from the impact of the falling stock market. As long as these companies can raise money cheaply, they can keep lending and making money. That's a real plus for the economy.
While investor trust has clearly suffered from the steady stream of revelations of corporate malfeasance, it does not always dictate which direction the stock market goes. At the top of the market, investors are far too bullish. And at the bottom, they are far too bearish. The same thing could be happening this time.
Ultimately, the performance of the stock market and the economy will be determined by tangibles: Productivity, profits, interest rates, and the perceived usefulness of technology investments. That's where the good news could come.
Mandel is BusinessWeek's Chief Economist