It is the best of times; it is the worst of times. That's what experts are saying about the state of the nation's economy right now, as opinions about a postwar recovery become increasingly polarized.
On Monday, for example, Salomon Smith Barney analyst Tobias Levkovich said earnings should improve going forward because of increases in capital spending, inventory building, pricing strength in the chip industry, cost-cutting and a weaker dollar. At the same time, however, Merrill Lynch analyst Richard Bernstein said the equity market remains "speculative" and that corporate profits will "disappoint."
Bernstein, who has been bearish for some time, increased his exposure to bonds Monday by putting more cash to work. His asset-allocation model now stands at 45% stocks, 45% bonds and 10% cash. Previously, Bernstein's weighting stood at 45% stocks, 35% bonds and 20% cash.
The U.S. stock market is at a critical juncture now that the war with Iraq is drawing to an end. Investors will soon find out whether the weakness in the economy over the last two months was predominantly tied to the war or symptomatic of more fundamental problems.
Bullish analysts like Levkovich believe the economy should rebound strongly once the war is over, as companies and consumers start spending again. Levkovich notes that after-tax profits, as reported by the Bureau of Economic Analysis, have improved sequentially for the past four quarters and should do so again in the first quarter, amid strength in the energy sector.
Among the factors that will help boost profit margins in the future, he believes, are increases in inflation and cost cuts. Since the year 2000, some 2 million jobs have been lost, which has helped reduce corporate costs by about $100 billion to $120 billion, he said. Furthermore, a weaker dollar should make currency translations more favorable.
"While many worry about the consumer, we would note that the pullback in energy prices removes the recent drag on consumer spending, while likely tax cuts (primarily bringing forward 2004 and 2006 tax cuts, as well as child tax credits) should sustain consumer demand," he said.
Although some economists agree with Levkovich's assessments, they worry that expectations are simply too high, saying it would take nothing short of an economic boom to satisfy investors at this point.
"History suggests that it is not the economy and corporate profits per se that move markets, but rather it is the gap between expectations for the economy and corporate profits and what actually happens that causes changes in asset valuations," said Merrill's Bernstein. "We strongly doubt that the lofty expectations for growth that are built into the financial markets can be surpassed."
Bernstein said the market is still highly speculative, with high-beta stocks outperforming low-beta, or less risky, stocks. Meanwhile, portfolio managers are positioning their portfolios for a strong recovery, according to a recent survey of fund managers by Merrill. Speculation is also evident in the bond market, where the yield curve is extremely steep and the duration of bond portfolios is at its lowest since 1994, he said.
Bernstein also disputes Levkovich's assertion that rising inflation will help the economy, noting that rising commodity prices are not being passed on through the consumer and that profit margins are being squeezed. In addition, he said that if inflation continues to rise, real wage growth will likely turn negative, thus hampering consumer spending.
"Despite the consensus that the economy is "coiled like a spring" and that inflation is returning, our indicators suggest an increasing probability that the economy and corporate profits will disappoint," he wrote in a research note. "Wall Street has consistently been overoptimistic regarding the economy and corporate profits, yet there has been little movement by investors to discount the lack of accuracy in those forecasts."
While economists debate the strength of the economic recovery later this year, other pundits continue to warn that a recession may still be on the horizon.
"Every period has its uncertainties and conflicts, but I don't think it's a stretch to argue that the current period poses an unusual degree of risk," said Nancy Kimelman, chief economist at SEI Investment. "A global recession, not to say depression, is still a distinct possibility."