Climbing The Wall

“There is a war in the Middle East. The President of the United States is about to open a new theater of war in Asia. The stock market has collapsed: computer, technology and conglomerate stocks have been particularly hit, declining by an average of 80 percent or more as the Dow Jones went down by 40%. A crisis of confidence threatens the survival of the stock exchange and has resulted in the near collapse of several major investment firms and the closing or liquidation of another hundred as a result of phony bookkeeping and capital flight. The city of New York, the financial capital of the world, is edging toward bankruptcy and many Americans have deep doubts about the political and economic system.”

“This is what happened in the early 1970s”, reminisces Felix Rohatyn in a recent issue of the New York Review of Books (11/21/02).

Indeed, following the highly speculative “two-tier market” of 1971-1972, the S&P 500 index declined almost 50 percent, to bottom (twice) in late 1974. What is often forgotten, however, is that the index recovered 72 percent in the following two years – in the face of still-dismal economic news and widespread worries about the world financial system. True to the old adage, the new bull market had to “climb a wall of worry”.

I am grateful to the International Strategy and Investment Group www.isigroup.com for the following sampling of 1975 headlines:

·        Economic recovery probably will be hampered and inflation refueled by anticipated sharp rises in energy prices, a Congressional Budget Office study projected.

·        The largest collapse in retailing history was marked by W.T Grant’s filing under Chapter 11 of the Bankruptcy Act.

·        New York City’s crisis deepened in the wake of a court ruling that cast doubt on the state’s ability to raise $500 million in the public debt market.

Incidentally, ISI also provides evidence of similar gloom in 1983, as stock prices were strongly rebounding after a long and deep bear market:

·        Nearly 600 banks are in trouble over bad loans, regulators say.

·        Prices plunged and yields rose for long-term Government securities and corporate bonds yesterday after Paul A. Volcker, chairman of the Federal Reserve, said that corporate credit needs were beginning to clash with Treasury borrowings to finance the Federal deficit.

·        Washington Public Power defaulted on $2.25 billion of bonds. The default, the largest in U.S. history, is expected to induce a flurry of investor lawsuits and to make it more difficult for utilities to borrow in the credit markets.

In the latest issue of The International Economy, David Hale (chief global economist for Zurich Financial Services) offers a brief and, as always, thoughtful reflection on the events that followed the September 11, 2001 terrorist attack.

Hale reminds us that the U.S. economy already had been in recession for three quarters before the attacks, because of the collapse in telecom and information technology capital spending that followed an extraordinary boom in the previous three years. American firms, he says, responded to the attacks by slashing prices, especially autos. This boosted retail sales in the last quarter of 2001 well beyond what had been anticipated before the attacks. The surge in consumer retail spending, together with corporate caution, drastically slashed business inventories. It was the easing of this liquidation, in the first quarter of this year, that naturally produced the strong, 5-percent bounce in the economy’s real output. However, the true surprise was that, instead of drying off, consumer spending then continued strong, aided by mortgage refinancings as well as accommodating monetary and fiscal policies.

On balance, Hale is not wildly optimistic about the future, and remains lucid about the challenges facing the economy in the years ahead. Nevertheless, I find him more sanguine than most of his peers and certainly at odds with some of the gloomiest forecasts making the headlines these days.

My own view is that surprises, in the months ahead, should be on the positive side. Even war with Iraq, while it might have serious implications for the very long term, would be unlikely to hurt the economy or the stock market more than the current uncertainty about it. Meanwhile, the news from the economy is likely to become more encouraging in the months ahead.

Most importantly, the Christmas retail season, though short this year, may well turn out much better than currently forecast based on recent trends. First of all, employment has been increasing again, while wages also have been rising faster than inflation.

As job availability improves and real personal incomes start growing again, American households should feel more confident about their financial outlook. Second, there has traditionally been a five-week lag between applications for mortgage refinancing and the actual receipt of the money by consumers. Recently, because of the surge in refinancing activity, that lag may have lengthened somewhat. This means that the high level of applications in September and early October should translate into more cash receipts by consumers during the current Christmas retailing season.

If this turns out to be the case, inventories should soon be exhausted, since they have continued to decline in the face of strong retail sales. Restocking during or after the Christmas season should boost industrial production rates – and corporate profits.

At this time, we expect a significant re-acceleration of economic activity in the United States during the winter. While this high pace of growth may not last more than a few quarters, it should be sufficiently at odds with the current gloomy assessment of the stock market to sustain the nascent rally for at least a few months.

November 19, 2002

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