Can Main Street Catch Up with Wall Street?

On the one hand, the Dow Jones industrial average once again danced around 10,000 last week. Earnings of Caterpillar (CAT), Google (GOOG), and Apple (AAPL) far exceeded expectations. If U.S. gross domestic product rebounds as expected on Oct. 29 and turns positive for the first time in 15 months, it would confirm that the recession ended in the third quarter, at least statistically.

Meanwhile, back on Main Street U.S.A., the picture is drastically different. Unemployment has doubled in a year, to 9.8% in September, and there are about six unemployed Americans for every job opening. Home foreclosure-related filings—including default notices, foreclosure auctions, and bank repossessions—are on pace to reach about 3.5 million this year, up from more than 2.3 million last year. Home prices are stabilizing, and sales of existing homes rose sharply in September, but much of the activity was spurred by the soon-to-expire federal tax credit for first-time home buyers. No wonder that 82% of Americans responding to an ABC News/Washington Post poll conducted Oct. 15-18 say the recession isn't over.

Gap Between Leading, Lagging Indicators It's normal for Wall Street to recover more quickly than the job market in the wake of a recession. Figures like stock prices and the difference between short- and long-term borrowing costs are known as "leading indicators" because they tend to be among the first to signal a recovery. Unemployment and consumer credit volumes fit into the "lagging indicators" category that bounce back afterward.

What's different in this recovery is the extent to which the leading indicators are soaring ahead of the lagging ones. Wall Street cheered on Oct. 22 when the Conference Board's measure of the economic outlook for the next three to six months rose a greater-than-expected 1%. But the same report saw the gauge of lagging indicators fall 0.3%. The worry is that if workers continue to lose their jobs and the ability to spend, the tentative recovery could morph into another downturn. In other words, while many economists are increasingly optimistic that a recovery is under way, some still warn that it could be W-shaped, meaning a second dip could be around the corner.

"The disconnect [between Wall Street earnings and other indicators] is surprising in magnitude, not direction," says David Rosenberg, chief economist and strategist for Gluskin Sheff & Associates (GS.TO), a Toronto wealth management firm. "I have never seen a 60% rally [in equities] over a seven-month period when 3 million jobs are lost."

Steep Layoffs "Exacerbated Downturn" Make no mistake, the recession has devastated the U.S. job market. Compared with the historical relationship between dips in GDP and job loss, layoffs in this recession have been about 65% deeper, according to an analysis by economists at JPMorgan Chase (JPM). "U.S. corporations savagely cut headcount during this recession," says David Hensley, global economist for JPMorgan Chase. "U.S. [employers] tend to be more aggressive than most in shedding workers, but the latest episode takes this to an extreme. The U.S. [GDP loss-to-layoff ratio] numbers are out of line, and that very definitely exacerbated the downturn."

Hensley is optimistic that companies will realize they've cut too much and start to hire again in the coming months, which would strengthen the economy's lagging indicators. But companies' hiring plans are as yet unclear. "We're now moving into growth despite the severe labor market," he says. "The question is, will we see a favorable behavioral shift in the corporate sector? Or will it continue to cut [staff] and undermine the ability of the economy to grow?"

Some investors worry that the stock market is overvalued considering the diminished spending power—and willingness to spend—of consumers. On Oct. 23 the Dow Jones industrial average lost 125 points after pessimistic earnings forecasts from railroad companies, which are considered an early indicator of economic activity because of their role in shipping goods. Jim Young, CEO of Union Pacific (UNP), said he expects the economy to "limp along" until unemployment starts to fall, while competitor Burlington Northern (BNI) released a weak forecast.

Overseas Markets May Fuel Disconnect Rosenberg, who is typically bearish, says the market has lost touch with economic fundamentals. "The market is pricing in earnings that won't be seen until well into 2013," he says. "Investors risk paying the price of a Cadillac for a Ford Focus."

But Ed Yardeni, president and chief strategist of investment firm Yardeni Research, says it's also possible that stock indexes could continue to rise even as U.S. workers continue to suffer. That could unfold if high rates of growth resume in China and the rest of the developing world. In other words, it's feasible that stocks in companies serving those emerging markets would gain value even as the U.S. economy—and its workers—stagnate.

"While there might be a protracted period of economic stagnation for the [1] billion people in the Old World, there are 2-3 billion people in the New World who want to prosper," says Yardeni.

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