A month ago, when the Dow Jones industrial average was threatening to fall through 9,000, investor nervousness was palpable but divorced from the improving economic outlook. After the Dow slipped below 7,800 on July 22, though, a new worry has emerged: At what point does the stock market's plunge fall back on the economy?
Don't look for an exact number. No economist could back up such a prediction. But a continued market slide will eventually destroy enough wealth and constrict overall financial conditions so much that households freeze up and businesses cannot finance their operations. The result would be reduced spending and increased saving by consumers, and a new round of cost-cutting and layoffs by businesses. In other words, the result would be a recession.
Are we there yet? Probably not, especially given the Dow's 489-point surge on July 24. But while there are still reasons for optimism, the sharp turn in investor psychology raises the risk of a new round of economic weakness. Consumers and businesses are losing confidence in the future. Bondholders see corporations as somewhat riskier borrowers than they did just last February (chart). Investor mistrust continues to generate uncertainty, the bane of efficiently functioning markets. And now, bourses abroad are falling as accounting questions go global.
Why is the stock market running counter to recent signs of improvement in the economy? By design, the economic data reflect only the benefits coming from the sharp cyclical adjustments of the past year and a half. But this time, the adjustments in the stock market are not economic. They are psychological. The economic numbers do not address the damage that has been done to the psyches of investors and corporate executives. Rising orders and slowing inflation can't repair growing mistrust among investors. And therein lies the biggest risk to the outlook.
THE OVERALL ADJUSTMENT in Wall Street's mind-set actually began two years ago, after the late-1990s tech and dot-com booms went bust. Investors, businesses, and consumers had to face a new reality of diminished expectations and increased risk. Now, trust is the overriding concern among investors. And the issue is not faith in the economy--it is a lack of faith in corporate honesty and government leadership. Investor optimism is below its post-September 11 level (chart).
As a result, investors are placing a high priority on government actions to underpin the market. According to a recent survey of 1,000 investors by UBS Warburg and Gallup Poll, 64% believe that new Securities & Exchange Commission regulations addressing accounting issues would have an "extremely large or fairly large" impact on the financial markets. Federal guidelines on ethical standards for corporate management and strict prison sentences for corporate managers convicted of fraud also scored high on potential market impact. The results suggest that quick action could buoy the market, turn around shareholder sentiment, and lessen the risks to the economy.
The risk to the expansion is if investor attitudes do not change fast enough. Consumers could start to save more of their income in an effort to make up for stock losses, causing a cutback in spending. Weaker demand, coupled with a further rise in risk premiums, would hit the still-shaky corporate sector. Keep in mind that by this past spring, businesses were beginning to open up their capital budgets. But new uncertainty and financing worries might arrest the nascent capital-spending recovery. Instead, business could feel the need to cut costs further by laying off more people. That could cut into consumer spending.
DESPITE ALL THESE DANGERS, however, the stock market probably has not fallen enough to cause a new recession. One reason for optimism is that the economy made huge cyclical adjustments during the 2001 recession. Businesses have already slashed inventories and costs. They continue to post stellar productivity gains, and they have largely eliminated excess production capacity. While investors obsess over the scandal du jour, what has gone unnoticed is that profits are now rising at a great many companies.
Meanwhile, consumer fundamentals remain stable even with the free-falling Dow. The three-month decline in jobless claims indicates the labor markets are stabilizing, and household incomes are growing comfortably faster than inflation. Jobs and incomes are always more important indicators of future consumer spending than trends in the stock market.
Obviously, punier stock portfolios are making consumers think twice about the future. However, because of falling mortgage rates--now down 75 basis points since March--and supportive demographics, strong housing demand is buoying home values, which has offset some of the loss of stock wealth.
Since the stock market peaked in March, 2000, households have lost more than $6 trillion in directly-owned equities and mutual funds, according to Fed data. During the same period, the values of all homes, less outstanding mortgages, rose by $1.2 trillion. To be sure, a 24% offset may not seem like much, but since there are more homeowners than shareholders, increasing home values benefit a larger segment of the spending public.
EQUALLY IMPORTANT, financial conditions have not deteriorated as much as the stock market drop would suggest. The Federal Reserve has indicated that it will keep monetary policy highly accommodative. And the weakness in commercial and industrial loans at banks reflects soft loan demand because of reduced inventory levels, not an unwillingness of banks to lend. C&I lending is closely correlated with inventory trends.
Further out on the yield curve, the bond market remains responsive to corporate credit needs. Since March, borrowing rates are down 45 basis points, to 6.11%, for AAA-rated companies; and 50 basis points, to 7.35%, for BBB-rated borrowers. Risk premiums that corporations must pay over and above the yield on a riskless Treasury bond have indeed risen, but they are still below the level seen right after September 11.
In addition, the 9% depreciation in the trade-weighted dollar since February is tantamount to an easing in monetary policy. It is helping manufacturers to boost exports and compete against imports, and it will lift profits from multinational operations.
The problem is that economic models simply aren't programmed to take account of mood swings such as those that have dominated Wall Street for the past few weeks. Nonetheless, attitudes are crucial to how people behave, even when faced with increasingly good news on jobs, production, inflation, and interest rates. And it's this disconnect between mistrust of the stock market and actual economic performance that makes the recovery so vulnerable right now.
By James C. Cooper & Kathleen Madigan