Market's Economic Optimism Carries Risks
{{#rendered}} {{/rendered}}Stocks have rallied over the past three months, raising hopes that the recession is over -- but Wall Street doesn't always get it right.
The stock market can be a leading indicator of the economy. In many cases, it has foreshadowed what would happen months in advance. Now, some are saying that the market's recent upturn is telling us that the first recession in ten years is over.
But investors would be wise not to believe all the hype and instead wait for stronger confirmation. Usually, one of the best indications of a rebound would be a clear sign that battered corporate earnings are turning around, analysts say.
{{#rendered}} {{/rendered}}Recessions in the United States since World War II have averaged nine to eleven months. Since this one started in March, it could already be coming to an end.
But not so fast, says Richard Sylla, a financial historian at New York University's Stern School of Business. There are reasons to believe that this recession may last longer than people think.
``Following the stock market bubble there was a major decline in stock prices, which did a lot of damage to people's wealth,'' said Sylla, who is Henry Kaufman Professor of the history of financial institutions and markets.
{{#rendered}} {{/rendered}}FUTURE EARNINGS
The recent upturn reflects a recovery from the long decline in stock prices. The Dow Jones Industrial average is up more than 20 percent, the Nasdaq up nearly 40 percent and the S & P 500 nearly 20 percent higher.
But even with the rebound, the major stock indexes ended 2001 down for the year. The rally started only after stocks hit bottom on Sept. 21 in the aftermath of the attacks on the World Trade Center and the Pentagon.
{{#rendered}} {{/rendered}}To sustain the stock market upturn into the new year, the economy will need to carry through on its recovery. Even if it does, the years of stocks returning 20 percent on average, as happened in the late 1990s, are almost certainly over.
The near-global upturn that helped back then isn't a factor anymore. Don't look for Europe and Japan to help the United States to get out of recession. They, too, are weak.
To spur growth here, Federal Reserve Chairman Alan Greenspan slashed rates 11 times last year, bringing them down to 40-year lows in the U.S. central bank's most aggressive campaign on record to slow a downturn.
{{#rendered}} {{/rendered}}Greenspan has built a record over the years of recognizing problems and responding with the right medicine. When weakness in the banking system contributed to the 1990-91 recession, Greenspan engineered lower rates to get growth back on track.
But some experts wonder how much more he can do this time to rescue the economy.
A potential lifeline for the economy was snatched back in late December when Congress failed to pass a stimulus package containing tax cuts and more government spending.
{{#rendered}} {{/rendered}}President Bush and his fellow Republicans in Congress favored tax breaks for businesses and individuals and extending aid for the growing ranks of the unemployed. But the Democrats, who control the Senate, said the plan was larded with benefits for corporations and tax breaks for the rich.
With the economy's crystal ball so clouded, investors may be wise to be cautious -- and wait for stronger corporate profits that almost inevitably spell gains in stocks.
REASONS TO BE CAUTIOUS
{{#rendered}} {{/rendered}}Corporate earnings were falling even before the hijacked plane attacks and outbreak of war battered consumer spending and worsened many corporations' financial position. Major high-tech and telecommunications companies were reeling from overproduction and unwise investments during the stock market bubble. Drug giants like Merck and Bristol-Myers recently have warned their earnings will stay flat or drop.
That means that even as the market fell hard, corporate profits fell in tandem, keeping stocks expensive in relation to underlying earnings.
``Stocks are more richly priced now because earnings have fallen so much,'' Sylla said.
{{#rendered}} {{/rendered}}Still more air needs to be let out of stock prices so they can come in line with earnings, say some analysts. On average, analysts expect profits of S&P 500 companies to fall 16 percent for the first quarter of 2002.
As a result, Sylla says, this is not the time to take all your money out of money market investments to chase the rally in stocks. He recommends putting no more than 50 percent in stocks and the rest in bonds and money markets.
``Then you are cushioned whatever happens,'' he says.
{{#rendered}} {{/rendered}}Things look good for later in the year. Recent data showing the rate of decline in the hard-hit manufacturing sector slowing down is a very good sign for the economy, says Alan Levenson, chief economist at T. Rowe Price. By late this year he sees gross domestic product, or GDP, rising at a 4 percent annual rate.
``The earnings outlook for the second half of the year from a GDP perspective should improve,'' says Levenson.
For the week, the Dow Jones industrial average rose 123 points to 10,260, the Nasdaq Composite gained 72 points to 2,059 and the S&P 500 was 12 points higher at 1,173.