Recipe for a Recovery: Wall Street Weighs In on What This Market Really Needs

Brett Fromson

A U.S. stock investor can be excused for feeling like a skater who has fallen through the ice on the pond. Every time he tries to pull himself out, the ice breaks and he's back in the icy drink courtesy of another lousy earnings warning like the one Microsoft(MSFT) announced Thursday. He's treading water, more than a bit scared and waiting to be rescued.

So what must happen to rescue the stock market in this colder-than-usual winter?

First and foremost, it's the economy, stupid. (Pay attention, Dubyah.) Slow growth means slow earnings growth. I wrote about this the day before yesterday, but let's spin it out some more.

What you need to know above all is, as Morgan Stanley Dean Witter global economist Stephen Roach wrote this week, "when does it make sense for investors to ignore the near-term perils and focus on the next upleg of the global business cycle?"

He answers his own question: "I suspect that it may be too early to take such a leap of faith. The near-term outlook for the world economy remains fraught with peril and we are now cutting our [economic growth] numbers for 2001 at a fast and furious pace." Roach expects 3.5% global economic growth next year, which is down 0.7% from his forecast of just two months ago.

Morgan's U.S. economist, Richard Berner, sees anemic real GDP growth in the world's largest economy too -- 1.3% for the first half of 2001. That is almost half the current economic growth rate.

Roach worries that such an abrupt downward shifting in the economy would strip the gears in a way we have not seen since the "very severe recession of 1981-82. ... There can be no mistake the perils of such an abrupt and sharp slowdown: Negative 'accelerator' effects could well be triggered -- an especially lethal dynamic for business capital spending and inventory decisions. That's the stuff of a cumulative cyclical contraction, which more often than not, culminates in outright recession."

Of course, Roach could be wrong. (He is an economist, after all.) What would it take for us to see an economic rebound? Energy prices must collapse, which would be the functional equivalent of a tax cut. Oil must return to $20-$25 a barrel. Similarly, the Federal Reserve and other central banks must ease monetary policy. We have seen a consistent tightening pattern worldwide this year by monetary authorities. Those drags on economic growth must reverse.

Even assuming we see lower oil and lower short-term interest rates, when will we know if they have done the trick? When will we have some good guess that we've avoided global recession? That's the problem facing investors. It's a tough call.

Roach is pretty pessimistic. He thinks that the risks to his current economic forecast "are very much on the downside. And that could well be the bottom line for world financial markets: While asset prices may now be discounting a soft landing, our quantitative strategist Joe Mezrich's analysis suggests that they have yet to come to grips with the full ramifications of a hard landing. Until that realization hits home, I suspect that any rebound play in the financial markets could prove premature."

Come on, It's Not That Bad!

For a rosier view, listen to Goldman Sachs' strategist Abby Joseph Cohen. She is obviously hearing it from her firm's big money clients who want to know when this market is really going to ramp up big time.

"Many investors are still waiting for catalysts that would move share prices higher. We expect these to include a greater comfort that the economy will continue to grow, but at a more moderate pace. We believe that less exuberant economic activity is consistent with a longer-lasting cycle, given the milder effects on inflation and the extra leeway it provides the Federal Reserve [to lower interest rates]," writes Cohen.

What is Cohen banking on? That energy prices will peak in "the coming weeks" and then move lower. She also assumes that the global economy outside the U.S. will chug along despite the slowdown in America. And third, that President-elect George W. Bush and the Congress will cut taxes and/or increase spending if need be.

So there you have it. If you agree with Cohen, plunge on in. If you agree more with Roach, don't.

If Cohen is right, you'll have time to get in on the rally because it will last. If she's wrong, then you survive to fight another day.

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