WSJ, April 26, 2007
By GREG IP
The stock market has been a lousy barometer of the economy.
From the beginning of 2004 through the first quarter of 2006, economic growth averaged an impressive 3.4%. The Dow Jones Industrial Average rose just 6%. Since then, economic growth has slowed to a little more than 2%, yet the blue-chip index has leapt 18%, ending yesterday's session at a record 13089.89, the first time it has closed above 13000.
So, is the stock market providing reassurance? Or is it out of touch?
Economists differ. David Rosenberg, chief North American economist at Merrill Lynch & Co., thinks the market is misleadingly optimistic. He says there is a "disconnect between how the economy is doing and the way the equity market is doing." The U.S. economy has just completed four quarters of annualized growth below 3%, which, he says, has never happened in 60 years without being followed by recession. While he doesn't forecast one, he puts the risks higher than generally realized.
But Ed Hyman, chief economist at ISI Group, a New York investment dealer, says the market has it right. Just as in 1985 and 1995, the Federal Reserve has raised interest rates enough to slow the economy and bring inflation under control. That reassures investors that even higher rates won't be needed later that could tip the economy into recession.
Mr. Hyman expects economic growth to slow further -- to an annual rate of 1.5% in the last nine months of this year -- and the Fed to cut short-term interest rates by three-quarters of a percentage point. The boost to stocks from lower rates should more than offset the drag from weaker growth and profits, he says.
At present, the stock market isn't responding to recent profit growth. In fact, profit growth has fallen sharply, and the outlook is clouded by slowing U.S. productivity growth, high fuel prices and the specter of protectionism that could interrupt the pace of globalization, which has boosted U.S. companies' profits from overseas. Rather, the rally that began last summer has been principally driven by the Fed's decision to stop raising interest rates.
The stock market has long been regarded as a leading economic indicator, though it sometimes sends the wrong signals. It reflects the collective judgment of millions of investors on the prospects for corporate profits, which are highly sensitive to economic fluctuations. However, other things also affect stocks: interest rates, the flow of money into and out of shares and investors' appetite for risk. That is why experts often disagree on how to interpret the market.
Mr. Hyman of ISI says the popular view that a strong stock market requires a strong economy is "just totally wrong." Beginning in the early 1980s, he says, the Fed adopted the practice of raising rates ahead of anticipated inflation pressure, often early in an expansion.
Such "pre-emptive" tightenings slowed growth but prevented an outbreak of higher inflation. During the tightening phase, stocks struggled to advance, even though profits were usually growing, as investors fretted the Fed would go too far and tip the economy into recession. Once the central bank stopped raising rates, investors concluded that with inflation under control, a recession was unlikely, and stocks took off again.
The Fed didn't always succeed: Its tightenings were followed by recession in 1990 and in 2001. Still, Mr. Hyman points to the United Kingdom, Australia and Canada -- which have grown without interruption since the early 1990s -- as proof that long expansions are likely as long as inflation stays tame. "It appears we are still in the tame inflation mode," he says.
Merrill's Mr. Rosenberg, in contrast, says the 1980s and 1990s were the exception, and sees no special factors that will extend the current expansion the way tax cuts and Internet mania did in the two previous expansions.
The Conference Board's index of leading indicators has declined on a year-to-year basis for three consecutive months. That is in spite of the rise in the stock market, which is one of the index's components. Mr. Rosenberg says every time it has done that in the past five decades a recession followed, with one exception: 1967. Among the components of the index recently pointing to a risk of recession are capital-goods orders, building permits and the fact that short-term interest rates are higher than long-term rates.
There also are other signs that the economic expansion is showing its age. One that former Fed Chairman Alan Greenspan has called attention to is profit margins. On an economy-wide basis, they hit a record high in the third quarter of last year before narrowing slightly in the fourth period. Mr. Greenspan's view is that the 1980s and 1990s expansions were helped both by a decline in long-term interest rates as investors adjusted to a low-inflation world, and a surprise acceleration in productivity growth in the 1990s driven by information technology. Neither factor is at work now.
But Steven Wieting, an economist at Citigroup Inc., says stocks have persistently lagged behind the growth in profits since the end of 2001. He figures investors are anticipating economic growth over the long term of just 2% to 2.5%. That is below many economists' estimates that the U.S. economy can grow at about 3% a year on average over time.
"The market, from a long-term context, isn't expecting a great deal out of the U.S. economy," he says.
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