There was a period there when the U.S. economy was Wall Street's rock, consistently growing faster than it was supposed to, defying all forecasts of impending doom.

Crises that were supposed to halt the U.S. expansion in its tracks -- financial trouble from abroad, a surging current account deficit, impending inflation, impending deflation, overleveraged speculators, Y2K -- got pushed to the side. Gradually the thought arose that through the miracle of technology, America had released itself from the cycle of boom and bust and entered the Nirvana of a new era. With the bogey of recession taken out of the mix, the risks of investing in stocks were greatly diminished, and valuations soared. At the trough of the 1991 recession, the benchmark

S&P 500

had a

price-to-earnings ratio of 16. In early 2000, it was nearly double that.

The Fire Sermon

Obviously, the U.S. was not as immune to slowdown as people had begun to think. High energy prices, a

Federal Reserve

that, with hindsight, got a little too rambunctious in its efforts to cool the economy and the fallout from last spring's rapid decline in speculative technology stocks put a damper on both consumer and corporate spending, and now many economists are, for the first time since 1993, forecasting the economy will contract this first quarter. The economic slowdown has translated into a profits slowdown for many companies, with consumer goods and capital-equipment makers, whose fortunes tend to ebb and flow with the U.S. economy, bearing the brunt of it and taking heavy hits in the stock market. Hurt worst have been the shares of technology companies, which had been priced as if profits could continue to grow even in the face of slowdown -- something that the just-finished fourth-quarter earnings season has shown was decidedly not the case.

The Fed has responded aggressively to the slowdown, cutting the fed funds target rate by a full point in January, with more cuts expected to follow. Already, there have been signs that the cuts are helping. Lower rates have led to a boom in

mortgage refinancings, and there are already some indications that homeowners are putting their freed-up capital to work. Corporate America, too, is getting into the act, taking advantage of the rate cuts by raising $75 billion -- a record -- in the bond market in January.

But the speed with which the Fed's easing can right the economy is unclear. As is almost always the case in a downturn, companies were somewhat unprepared for the drop-off in demand. Inventories, capacity were too high. If production cuts allow businesses to work off those excesses quickly, then the economy could rebound sharply. If not, or if the layoffs implicit in production cuts lead to a further deterioration in confidence, then the downturn could be a more protracted affair.

Which of these will happen -- whether the U.S. will have a sharp, V-shaped recovery, or a more gradual U -- will have a profound effect on corporate profits. A sharp rebound would suggest that the worst will soon be behind cyclical companies, the excesses trimmed and fresh profits growth in the offing. This outlook is certainly the consensus among Wall Street's sell-side analysts, who are forecasting an outright earnings contraction among S&P 500 companies in the first half 2001, followed by 6.8% year-on-year growth in the third quarter and a whopping 17.3% in the fourth, according to

First Call/Thomson Financial

. It's a view of the world that many economists have a problem with.

"People who talk about a V-shaped recovery just talk about it -- I don't think they understand how the economy really works," says

Banc of America Securities

chief economist Mickey Levy.

Levy concurs with the idea that the economy is on the mend, pointing not just to the pickup in refinancing activity and bond issuance, but to the apparent speed with which American companies have cleared excess stock off their shelves. Indeed, the latest report on

business inventories from the

Census Bureau

showed that in January, for the first time in several months, the U.S. inventory-to-sales ratio actually fell.

Samsara

But just because U.S. companies' operations may soon be lean and trim and ready for the beach, a return to robust growth does not necessarily follow. The experience of the recent cooling in the economy may well give consumers pause before spending their money freely again. The U.S. savings rate turned negative in the latter half of 2000 -- as a whole, we were spending more than we made -- and many of us might decide to shore up our finances before going out and buying another SUV.

"It was eight years in a row where consumption grew faster than income," says

Goldman Sachs

head of economic research Bill Dudley. "Working that off in three months seems unlikely." At a minimum, it seems that consumer spending growth will slow to the rate the income is growing -- with the possibility that it slips below income growth for a little while.

Many companies are in similar straits. One of the driving forces behind the U.S. 10-year boom has been the incredible amount of money businesses have put into buying new equipment. For the last few years, capital expenditures have grown at more than 15% -- a much quicker pace than companies' coffers were growing. Companies were comfortable doing that because they believed in their futures -- the productivity gains they got from spending now would give them stronger future growth. As much as anyone else, they bought the proposition that the U.S. had somehow been made immune to economic downturn. "Now," says

J.P. Morgan Chase

equity strategist Doug Cliggott, "the struts supporting an environment where companies were comfortable supporting capex in excess of cash flow have cracks in them."

There are other issues at work. During the latter stages of the boom, companies were not just increasing inventories, they were buying new equipment and building new factories -- increasing their capacity for production in expectation that they would need to produce more. Now it seems they may have been too optimistic about demand, and capacity utilization has slipped -- in some areas, like technology, dramatically. That excess capacity will force many businesses to rein in their expansion plans, and in some cases it may also lead to further job reductions. The consumer analog to excess capacity may be what is called the "full closet" effect -- after the longest-ever expansion in U.S. history, many of us already have all the new washers and dryers, new PCs and new cars that we need.

To find out what this means for the next few quarters' earnings, read Part 2.