November 1, 2002
Why The Stock Market’s Applaud an Economy That is Teetering on the Brink of Recession
Today’s Data
The ISM Manufacturing index came in slightly below expectations, the U.S. economy lost 5,000 jobs in October (initial estimate), and the unemployment rate ticked up a notch to 5.7%. Further, personal savings jumped to 4.2% in September, spending actually declined (while income was up), and October automobile sales were exceptionally weak, albeit partially because sales were compared to a record breaking month in October 2001.
Given that none of the above reports is ‘good news’ it can easily be seen why the markets closed higher today: the Fed is going to cut! As Reuters reports, most economists see the Fed cutting interest rates next week by ¼ point. Furthermore, Fed futures, already pricing in a 90% chance of a Fed cut at the opening bell, rallied sharply following a slightly weaker than expected ISM report.
To reiterate Monday’s sentiments, the pattern is that the markets like Fed cuts.
“For those of you who do not believe investors are silly enough to get excited about another rate cut remember why the markers are supposedly rallying today (company ABC beats slashed EPS estimates by 2 pennies!). Moreover, remember that investors do not have to get excited for the markets to rally. Rather, all that is required for prices to edge higher is for the short-selling-shaker to be pulled away from the table, and for a pinch of short covering to be thrown into the mix. To be sure, not even short sellers are likely to become overly stimulated by bad economic news knowing that such news could prompt the Fed to cut interest rates in a few days time.” Oct 30, 02
Product of Conditioning
That investors are, once again, rallying around the expected actions of the Fed would seem to be illogical. After all, the Fed slashed rates 11 times in 2002 and economists continually reiterated ‘the cuts usually kick-in within 12-months!’ – and here we are nearly 12 months from the last Federal Reserve Board intervention and they are preparing to cut again.
However, by living through one the briefest and most pleasant recessions in history (Q101-Q201-Q301), one could speculate that investor’s have come to be fearful of recessions yet extremely excited about the post recession recovery. Accordingly, as economic report after economic report confirms that the economic situation is becoming more grim this increases the odds that things are about to get better.
Suffice it to say, buying into to this strain of reasoning can be a dangerous pursuit. To be sure, the Fed could cut interest rates next week and nothing may happen – consumers may still continue to send less and businesses may continue to spend little. However, and this point seems to be key, who is buying stocks based upon what the economy may do after next week? While certainly possible, it is nonetheless unlikely that anyone is holding the steadfast opinion that another cut will cure all that ails the U.S. economy.
Speculation aside, the majority of stocks carry with them more risks than potential rewards. The basics tell us that valuations are high and that forward estimates will be knocked lower, and, on a more complex note, the macro economic outlook could not be more troubling – consumer debt as a percentage of disposable income has never been higher coming out of a recession and capacity utilization has rarely ever been lower (which suggests businesses do not need to undertake new investments). As such, exactly what can drive economic growth going forward?
The truth is that no one, be it the Wall Street optimist or cheery economist, is able to provide an acceptable answer to this question. Rather, the conclusions offered essentially argue that mediocrity is not cause for alarm – the economy may be sinking but since it hasn’t sunk it may stay afloat.
As the U.S. economy continues to show signs of unraveling most investors and economists are keeping their fingers crossed -- they hope that as the teeter-totter goes down it becomes more likely to go up. This type of simplistic contrarianism is extremely accurate with long run thinking, as historical economic boom/bust cycles aptly demonstrate. Nevertheless, with respect to the stock markets it is worth remembering that prices have already rallied…
Yes, the stock markets love an economy that is teetering on the brink of recession. What the markets do not like, however, is an economy that enters a recession or doesn’t rebound strongly from a near recession.
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