When future historians analyze the causes of the great world recession of 2001-2002, they may point scornfully at our otherwise-enlightened era's ruinous appetite for false beliefs on Wall Street and in Washington.
In the late '90s, investors' false belief that the Web changed everything led to a fantastic misallocation of capital -- and we ended up with too many telecom networks, too many dot-com companies and way too much telecom equipment.
Meanwhile, our government developed a false belief that we could prevent attacks on our transportation and financial infrastructure without spending a dime on new airport, border, military or police security. And down in Texas, small-town energy executives Kenneth Lay and Andrew Fastow developed the false belief they could mix math, mendacity and moxie to build
into a merchant-trading monolith -- and possibly the greatest Ponzi scheme of all time.
The money-vaporizing bankruptcies of companies such as dot-bomb
and gas-bomb Enron that followed weren't just about greed, as bears say. They were events that illuminated how gullible and complacent we had all become. How trusting of celebrity, standing and pedigree. How blindly hopeful that things would just turn out all right.
But often things don't turn out -- and in a moment I'm going to explain why the current rally in the market won't, either. Perhaps the debacles will push U.S. investors to desert that strange financial fantasia where more attention is paid to pronouncements by a corrupt web of Wall Street stock analysts and underwriters than to raw facts and common sense.
Let's look at what facts and common sense suggest for the rest of investors today.
Metrics Don't Look Promising
December dawned with the market at a poorly lit crossroads where traders' enthusiasm over the war on terrorism crashed into fears that the economic recovery might not be on track. For the past two months, stock prices have benefited both from a psychological "defiance dividend" as well as from a perception that recession-battered companies' growth rates will begin to revert early next year to levels of the late '90s.
If you accept the notion that lasting upward moves in stock prices only follow sustainable upward moves in the companies' fundamental prospects -- and that large companies' prospects are closely tied to overall U.S. growth -- then to be bullish today you are making a bet that the economy will rebound strongly in early 2002.
Determining the likelihood of rebound doesn't need to be a gut-level guessing game. Independent economists such as Lakshman Achuthan of the Economic Cycle Research Institute have become good at weighing a variety of metrics to determine the timing of the business cycle.
Achuthan's statement in August that a recession had begun near the end of the first quarter of the year was both contrarian and prophetic, considering that there were many economists at the time claiming that recession was still avoidable. (The National Bureau of Economic Research declared last week that the recession began in March.)
Today Acuthan says facts and figures still line up powerfully against investors' hopes for an early 2002 recovery. In fact, he doesn't see the likelihood of a rebound before July. In an interview Friday, he listed three positives weighing in favor of a recovery and eight against. Here they are:
Rise in equity values.
Stock-market moves are a single imperfect ingredient, not the whole enchilada, in economic forecasts. They do lead economic recoveries, but they can also give many false signals. So while it's important to note that the broad market's powerful move up from the Sept. 21 low provides evidence suggesting that an economic rebound is at hand, it's likewise important to realize that it's only half the story.
The bad news is that most people seem to think that the typical lead is six months, but Achuthan says that 50% of the time since World War II the lead has been four months, 25% of the time it's been five months and 25% of the time it's been three months. So if you believe that the September low was the real thing, then the economic rebound has to start in December, January or February.
Will it? Well, great minds will differ. But the well-regarded National Bureau of Economic Research speculated in its press conference that the recovery would begin in July 2002. If you date the stock recovery back three to five months from then, you would expect a cyclical market low -- that is, prices below the September 2001 low -- between February and April 2002. Achuthan notes that his percentages are facts, not guesses, which encompass all cycles in the postwar era. "It's possible we'll get a longer lead this time," he said, "but given our experience, it's not likely."
Decline in energy prices.
Oil and natural-gas prices have declined sharply in the past nine months, giving consumers a big boost in their available funds for spending on stuff that can revive the economy. Enough said.
Explosion in the money supply.
Eleven interest-rate cuts since January in the United States and other measures in Europe have flooded the global economy with an unprecedented amount of cheap money. Lower borrowing costs are bound to result in higher business and consumer spending - and whatever's left is almost certainly bound to find its way into stocks and support the market.
Initial claims for unemployment insurance.
Until last week, the bulls were able to argue that this leading indicator of employment had made a change for the better. But on Thursday the thesis was trashed because initial claims spiked back up. The level of jobless claims has to fall in a persistent way before economists can forecast recovery.
The market for housing has been great, but when economists look for turning points, they turn to the building permits report. Despite a surprising rise in new-home sales, permits -- especially for multifamily housing -- have been slipping since the start of 2001. In the past few months, they have accelerated in the wrong direction. The number needs to first stop falling, and then rise, to provide a signal that an economic recovery is imminent.
The JOC-ECRI Industrial Price Index -- made up of 18 components divided into energy, metals, textiles and miscellaneous (e.g. hides, tallow and plywood) -- is resting at multidecade lows. If a nascent recovery were at hand, there should be enough demand to cause a rise in commodity prices. A couple of individual commodity prices have risen lately -- copper's an example -- but turning points are made when the whole slate of commodities rises together. The global recession has pushed the price of rubber to a 30-year low, in spite of the rise in U.S. auto sales thanks to 0% financing. Achuthan says he would like to see a pronounced, pervasive and persistent move up in the index before using it to forecast a recovery.
Bond quality spreads.
Just before recoveries, the price differential between junk bonds and investment-grade bonds -- e.g., between bonds rated BBB and AAA -- sharply narrows. Currently the spread is relatively wide. Thus bond buyers are not exhibiting the sort of optimism seen in the stock market.
Achuthan looks closely at several of the answers given by respondents to the National Association of Purchasing Management (NAPM) survey each month. Response to whether "vendor performance" is high or low has been one of the most prophetic in the past. He's a contrarian on this one, because if performance is high, then there's not enough demand. He wants to hear that things are being delivered slowly. "If this deteriorates a bit, then vendors are busy -- and that's a very good sign," the economist said.
New factory orders.
The "new order" series in the NAPM report plunged to a two-decade low in November. This can be a noisy number, with a single big Pentagon order distorting results. But if you strip defense out of new orders and compare November to a preattack month like August, Achuthan said, you see that the indicator does not forecast an imminent recovery.
Price to unit labor cost.
This is a fancy measure of profitability, and Achuthan pronounces it "really ugly" at this time. It's almost impossible now for companies to raise prices, and, in a period of diminished sales, that means that profits get hit. When you consider that profits are required to fund corporate investment, you have a real problem with the business side of the recovery. Firms are trying to cut costs by firing record numbers of employees, but at this point in the cycle, layoffs can cost more in severance and other expenses than they actually save.
Synchronous global recession.
Very often there are pockets of strength abroad to offset the weakness in the United States. In the 1991 U.S. recession, for instance, both Europe and Asia were still expanding. But right now big multinationals such as
aren't making money anywhere -- something that hasn't happened in 25 years. German economists just announced that their economy had slid into a contraction, and Japan might be on the verge of its worst recession in a whole decade of financial capitulation.
In short, Achuthan warns that stocks may have once again forecast a "false dawn." He knows, and I know, and you know, that eventually the United States and the world will experience a full and complete economic recovery. But it is critical for investors to think for themselves and get the timing right -- and not to simply hope that the market has gotten the timing right.
So let's end with some math. In the spring, it turned out that a 1948-point move in the
industrials from the low of March 22 to the high of May 21 incorrectly forecast an autumn recovery -- and the Dow went on to plunge 3102 points before turning around on Sept. 21. If the same script were run from current levels, the Dow would retrace back to the 6750 area -- exactly its 10-year moving average, last visited in March 1997.
I don't think that's likely to happen -- it's simply not the right time of year for a decline, and this market has been an absolute Sir Edmund Hillary when it comes to climbing the wall of worry. At worst, it's fair to expect a return of the September lows by February. But you never know.
At the time of publication, Jon Markman owned or controlled shares in none of the equities mentioned in this column.