U.S.: Don't Blame the Economy for the Bear Market

Blinded by corporate scandals, investors are ignoring good news

Here's a disturbing fact: After the September 11 attacks, the Dow Jones industrial average lost 6.8% of its value before finding a bottom. Since news of the corporate scandals began to snowball in mid-May, the Dow is down 18%. In other words, corporate wrongdoers have done more than twice as much damage to the U.S. stock markets as Osama bin Laden.

Nevertheless, the growling bear on Wall Street is in stark contrast to the industrious bees now at work in the economy. The latest data show the real economy is gathering a good bit of momentum going into the second half. In June, shoppers were buying with gusto, builders broke ground on an impressive number of new houses, and industrial output picked up (chart).

After a shaky second quarter, real gross domestic product entered the third quarter with a good head of steam even as the stock market was tanking. One reason for the disconnect: The tightening of financial conditions, caused by the drop in stock prices, has been offset by a sizable decline in long-term interest rates and a depreciation in the dollar. Plus, the Federal Reserve seems content to leave short-term rates at their current stimulative level for the rest of the year.

That much was clear from Fed Chairman Alan Greenspan's semiannual testimony on monetary policy on July 16-17. While Greenspan's assessment of the economy was upbeat, he gave no hint that policymakers were anywhere close to lifting interest rates. He said that with inflation contained and likely to remain so, the Fed has chosen to maintain its accommodative policy stance until demand by consumers and businesses is on a solid path. That could take a while, Greenspan said, because "while final demand has been increasing, the pace of forward momentum remains uncertain."

GIVEN THE CLIMATE on Wall Street, Greenspan had to walk a tightrope. He needed to calm the financial markets for the sake of the economy, but he did not want investors to think the Fed would step in to rescue the stock market from a debacle that was not caused by the economy. The Fed chief made it clear that recent speculation about a rate cut is wrongheaded. When questioned about a reduction by Senator Paul S. Sarbanes (D-Md.), Greenspan all but said it wasn't necessary because "the economy is improving."

Indeed, the Fed boosted its forecast for 2002 growth substantially, from a range of 2.5% to 3% in February to 3.5% to 3.75%, and it sees growth picking up in 2003 (table). Worth noting, Greenspan offered up positive remarks about the trends in productivity and profits, and he said that with the elimination of excess capacity now well advanced, "business fixed investment may be set to improve," although the pace will be gradual and uneven, especially in light of the telecom glut.

Greenspan alluded to the disconnect between the economy's encouraging prospects and Wall Street's skittishness, which could limit the economy's growth. Sounding more like a tent-revival preacher than a central banker, the Fed chief spoke at length about the corporate scandals, often with a rare eloquence stemming from his deep-seated belief that trust is a cornerstone of free markets and that free markets mean free flow of information, unencumbered by falsification and fraud. Greenspan railed against poorly structured stock options as a key source of "infectious greed" among too many executives.

THE LATEST DATA back up the chairman's optimism on the economy. Consumers hit the malls in June, with retail sales scoring a 1.1% advance, recovering all of May's decline. And early reports from car dealers for July suggest that buyers are responding to new zero-rate financing deals.

Despite the stock market's hit to recent consumer-confidence readings, gradual improvement in the job markets and income prospects appear to be outweighing market worries. Another reason: There are more homeowners than shareholders, and rising home values remain the most important source of household wealth. Consumer spending, which slowed in the second quarter, appears set to grow at a faster pace this quarter. That, plus the ongoing, albeit uneven, firming of capital spending, bodes well for a pickup in overall GDP growth.

A solid recovery is also increasingly evident in the industrial sector, where output in June surged 0.8%. Manufacturing production alone jumped 0.7%. Excluding an auto-industry distortion in 1998, the June rise in industrial production was the largest since 1997. For the second quarter, manufacturing output rose at an annual rate of 4.2%, the strongest quarterly showing in two years.

The production increase spans high-tech and low-tech sectors. In particular, output of high-tech equipment grew at an annual rate of 26.5% last quarter after a 23.7% gain in the first quarter, led by computers, office equipment, and semiconductors.

OVERALL PRODUCTION is picking up in large part because companies have cut their inventories so much that they risk losing sales if they don't beef them up. Inventories of manufacturers, wholesalers, and retailers rose 0.2% in May, the first increase in 1 1/2 years. Still, the ratio of inventories to sales is well below its long-term trend, suggesting that stockpiles are lower than desired, a point corroborated by recent industrial surveys of customer inventories (chart).

Also, manufacturers have been given three lifts from the depreciation of the dollar since February. For starters, the cheaper dollar hikes import prices, helping factories compete in U.S. markets and providing cover to nudge up their own prices. Two, it makes exports cheaper in foreign markets. And three, it boosts profits of multinational operations when overseas earnings are translated into dollars, an impact that will begin to show up in second-quarter profit reports.

However, Greenspan advised investors to pay close attention to the Commerce Dept.'s accounting of overall corporate earnings. Commerce data exclude a number of one-time charges that show up in shareholder reports. They attempt to expense the value of stock options. Most important, the chairman said, they are "far less subject to the spin evident in reports to shareholders in recent years." Incidentally, this measure of profits has looked very strong in recent quarters, reflecting strong productivity gains and declining unit labor costs.

Those trends underlie the chairman's cautiously optimistic outlook. The market's free fall still looms as a risk to the recovery. But Greenspan understands that Wall Street's woes are a product of human weakness, not economic frailty. "It is not that humans have become any more greedy," Greenspan said. "It's that the avenues to express greed had grown so enormously."

By James C. Cooper & Kathleen Madigan

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