The American stock market has developed a well-rehearsed reaction to stress: a rapid move from panic to denial. More specifically, the reaction is to envision a V-shaped cycle whenever negative news appears. This amounts to saying, "Sure, things are bad and will be for a few months, but then they will get better again." A rapid descent will be followed by a rapid rebound. This contrasts with a U-shaped scenario, in which decline is followed by a stretch in the doldrums before recovery occurs. This temporarily constructive form of denial allows the stock market to embrace negative news on earnings and the economy as a harbinger of better times ahead. The V-shaped recovery forecast has already been invoked twice as an excuse to ignore bad news in what, so far, has turned out to be a continuing bear market in stocks: once after the sharp earnings disappointments and investment collapse of last fall, and again after the terrorist attacks of September 11.
Dismissing bad news out of faith in the ever-receding V-shaped recovery is dangerous because it delays a market capitulation to a deteriorating global economic environment, and that capitulation is a necessary precondition for ultimate recovery. It will come once the realization that we are entering a protracted recession leads to another nasty sell-off in stocks.
Two Invocations of the "V"
Following the shock of initial earnings disappointments last fall, market players had, by early winter, postulated the first V-shaped-recovery story. It said: "Yes, we have a sharp slowdown on our hands, but it is just an inventory correction that will be over by midyear. The economy will bounce back in the second half of 2001." Comforted by the reassuring "V" image, the stock market rallied briefly in January by about 8 percent after having dropped 12 percent since November 2000. ("Stock market" here refers to the broad S&P 500 Index. Other indices, such as NASDAQ, with a heavier concentration of technology and communication stocks, are more volatile.) But then stocks dropped again, and more sharply— by 20 percent in February and March— when confronted by the reality of awful earnings reports, before managing to rally again by 19 percent in the spring on the renewed hope of a second-half recovery.
The problem with the first V-shaped recovery story, which provided some comfort to stock markets during the first half of 2001, was the arrival of a second half that brought no recovery, either for the economy or for earnings. By August, after 3 full percentage points of Federal Reserve easing and $38 billion in tax rebate checks were accompanied by a relentless slowdown in the growth of profits and investments, the stock market fell sharply, by another 20 percent from mid-August to the September 21 lows after the terrorist attacks.
But then, buoyed by the hope of another V-shaped recovery to start in the first quarter of 2002, the stock market rallied by 15 percent off of its September 21 lows by mid-October. To its credit, during the period following the terrorist attacks, the stock market sorted through the obvious first order effects and produced large changes in the relative prices of stocks, depressing the prices of obvious losers, such as hotels, motels, and airlines, and pushing up the prices of defense and communications stocks.
The rationale for this second V-shaped recovery story was initially based on policy responses to the attacks. The fear of additional negative fallout for the economy from the increased uncertainty arising from the terrorist attacks produced additional policy responses. These included another full percentage point in interest rate cuts by the Federal Reserve and enactment of about $40 billion in immediate relief from the federal government, largely to New York and the airlines. The prospect also emerged of an additional $60 billion to $100 billion of federal fiscal stimulus in the form of increased tax cuts and more government spending on security infrastructure.
The aftermath of the terrorist attacks produced the ideal environment for the "look over the valley" aspect of the V-shaped recovery scenario. Since we "know" that the economic data following September 11 will be terrible, so the story goes, we can simply ignore it in the belief that it will not continue. The rationale is being applied again to justify ignoring bad corporate earnings, this time during the second half of 2001. Those earnings were to have improved based on the prospects held forth during the first half of the year, but the negative fallout from the terrorist attacks now provides an excuse for the fact that earnings have continued to deteriorate in the second half.
Rationale for the Second Expected "V" Upturn
The sharp recovery scenario for the U.S. economy and corporate earnings that has been advertised for the first half of 2002 has come to be based on two notions: first, that the lagged effects of monetary and fiscal policy measures enacted in 2001 will provide a boost to the economy and, second, that this is a normal business cycle, with a recession probably having begun during the third quarter of 2001. Since the contraction phase of most postwar recessions has lasted an average of eleven months, recovery should begin no later than the second quarter of 2002, and since the stock market will invariably spot the recovery coming, it should begin to rise in earnest early in 2002.
The fact that the stock market rose 15 percent off its September 21 lows by mid-October is attributed to the supposed perspicacity of portfolio managers and to the additional boost from more Fed rate cutting and more federal government fiscal stimulus. Perhaps a sounder base for the stock market rally came from the fact that stocks have been going down for nearly a year and a half and had dropped 22 percent from their February highs to the September 21 lows. For equity managers accustomed to the eighteen-year bull market running from 1982 through early 2000, such a sharp drop in equity prices provides irresistible temptation.
Unfortunately, purchasing stocks in this environment also requires a hefty dose of denial (or blindness) about the outlook for profits and, in particular, about the outlook for the total dollar value of goods and services produced by the economy. Such denial can be dangerous. Persistent denial of the implications of weaker growth is a necessary condition for a mild recession to become a serious recession.
Falling Inflation and Output Crush Profits
The best index of the size of the economic pie available to households and businesses is the dollar value of GDP, usually called nominal GDP to distinguish it from real, or inflation-adjusted, GDP. One of the underlying problems confronting households and businesses has been the sharp drop in the growth of the dollar value of GDP, which is the result of plummeting real growth accompanied by lower inflation.
The best way to measure nominal GDP is to look at its level relative to a year ago to see beyond the quarterly gyrations. Nominal year-over-year GDP growth was 3.5 percent in the second quarter of this year-quite low by historical standards and sharply lower than the year-over-year GDP growth in the second quarter of 2000, which was 7.6 percent. The last sub-3 percent reading on year-over-year nominal GDP growth occurred during the 1990-1991 recession. If nominal GDP in the third quarter of this year was about equal to its level in the second quarter, a likelihood in view of negative real growth during the third quarter and low inflation, the result would be a drop in year-over-year nominal GDP growth to 2.7 percent. Sharply lower growth in this quarter could push nominal GDP down to a level consistent with about zero year-over-year growth. That would be the lowest level of nominal year-over-year GDP growth since the early 1950s, when inflation was very low and negative real growth was more likely to result in falling nominal GDP growth.
The disinflationary trends in price indices that include the broad categories of goods and services depressing nominal GDP growth are reflecting outright deflation in commodity markets. Prices of commodities used as inputs in the production process have dropped sharply over the past year, at a rate of 15 to 20 percent depending on the index used. The price of oil is 35 percent below its level a year ago, despite cutbacks in supply by OPEC. While lower commodity prices, especially those used as inputs in the production process, can be helpful, they are also indicative of a sharp drop in global demand for products made with those commodities.
The weak outlook for nominal GDP growth presents a major problem for the V-shaped recovery scenario. If the total dollar value of the economy's output is static or falling while labor costs are rising by more than 4 percent a year, corporate profits remain under heavy negative pressure. Labor costs on average constitute two-thirds of the total cost of producers, so not even lower commodity prices can compensate for the strain on profits that arises from a persistent increase in labor costs.
Firms confronted with rising negative pressure on profits from rising labor costs respond by laying off workers. The September employment report, whose numbers reflect events before September 11, showed a job loss of 199,000, with total hours worked in the three months ending in September falling at a 3.1 percent annual rate. Because hours worked is a good proxy for GDP, negative 2.5 percent growth in the third quarter will not be a surprise.
Since September 11, the four-week moving average of new claims for unemployment insurance has risen from 410,000 to 463,000 while continuing claims for unemployment have risen from 3.276 million to 3.529 million. The sharp rise in both of these indices means that layoffs have accelerated while workers already collecting unemployment benefits are not finding new jobs.
The response of firms to falling profits-cutting workers-feeds back negatively on consumption, which, as two-thirds of overall GDP, pushes down GDP growth. This dynamic accounts for forecasts of contraction in the fourth quarter of this year ranging from a negative 1 percent to a negative 4 percent. Almost all forecasters, however, expect positive growth during the first half of next year, based somehow on the notion that layoffs will cease and demand will recover. It is not yet clear how this turnaround will occur so quickly, especially in view of falling nominal GDP growth in the United States, Japan, and Europe, not to mention in emerging markets.
Demand growth may recover sometime next year, but it seems premature to count on it and to push equity prices up to what are still aggressive levels relative to earnings. The acceleration of layoffs in response to demand weakness has only begun and could continue well into next year, during which time consumption spending is unlikely to recover. Investment spending has been weak for most of this year, but the level of investment relative to GDP at about 12.5 percent is still well above the historic norms of about 11 percent. This implies that investment spending could continue to fall for several more quarters. After Japan's equity market bubble burst in early 1990, investment fell for three years.
Can Fiscal Stimulus Turn the Economy Around?
The result from the first dose of fiscal stimulus, the $38 billion in tax rebate checks distributed over the summer, is not encouraging. By some estimates, only 18 percent of the rebate was spent, meaning that about $7 billion in additional spending (0.07 percent of GDP) served only to cushion the slowdown in consumption growth during the third quarter. Consumption was slowing because of falling employment, and the drop in employment was intensifying before September 11.
Going forward, additional fiscal stimulus may total about $150 billion, provided that Congress can agree on a stimulus package before departing Washington in November. However, with the Bush administration apparently wishing to cap additional stimulus, beyond the $40 to $50 billion already in effect, at about $75 billion, for a maximum total of $125 billion, it seems a stretch to count on major help from that quarter in producing a recovery. The sharp drop in nominal GDP growth, the best proxy for future tax revenues, will result in sharp spending reductions by state and local governments that will try to avoid deficits as their tax revenues fall. State and local government spending totals twice that of federal spending, so on the whole, the government sector may be a drag on spending.
It is easy for weaker consumption growth to swamp government stimulus. A 1 percentage point drop in the growth of consumption subtracts $67 billion from demand, which, coupled with lower state and government spending, lower investment, and falling exports as the global economy continues to slow, could easily leave aggregate spending lower than it was last year, even with fiscal stimulus of around $125 to $150 billion.
It is unfortunate that the "Rubin fallacy," which is named after former Treasury secretary Robert Rubin and which suggests that somehow the great prosperity of the 1990s was due to budget surpluses and the resultant paydown of federal debt, has taken hold in Washington at a time when fiscal stimulus is much needed. Many of the same people who heralded the burst of innovation and growth from the private sector, which generated the tax revenues to pay down the debt, have forgotten that the prosperity caused the debt paydown, not the other way around.
At times of economic weakness, governments should increase their borrowing to finance lower taxes and to lay the groundwork for a sustainable recovery. In our case, sharp tax cuts would stimulate demand and rejuvenate investment growth. The only result would be a pause of a year or two in paying down debt and a modest accumulation of perhaps $100 billion in additional debt. But somewhat ironically, the formation of the V-shaped recovery scenario and the attendant rise in stock prices will probably result in less fiscal stimulus as Congress, mesmerized by the Rubin fallacy, backs away from aggressive tax cuts.
Skeptics regarding fiscal stimulus compound the Rubin fallacy by suggesting that larger budget deficits push up long-term interest rates and choke off private investment. The fact is that since July the expected federal budget outlook for fiscal year 2002 has moved from a surplus of $175 billion to a deficit of $25 billion (a swing of $200 billion), while interest rates on long-term Treasury notes have fallen by a full percentage point. The drop in interest rates reflects a sharply weaker economy, thereby underscoring the need for more fiscal stimulus.
Recovery in 2002?
The economy and the stock market may or may not recover sometime in 2002. But, sometime before they do recover, market players will realize two things. First, the economy was weakening rapidly before the terrorist attacks on September 11, and second, those attacks sharply increased uncertainty and therefore, for a time at least, will depress demand growth both by households and businesses. Those two facts mean that the economy and earnings will deteriorate very sharply in coming months, thereby producing a more protracted recession than the "normal" eleven months currently expected.
The market's reflexive denial of both the negative path of the economy before September 11 and the negative economic impact of the events of September 11 only make matters worse. The most probable outcome will be a sharp market sell-off either later this year or early next year as earnings disappointments and lower growth exceed the most negative of current forecasts. Maybe those events will produce a capitulation sell-off of the stock market that leads from the panic and denial phase of this serious economic contraction to the recovery phase. Meanwhile, nominal GDP growth rates close to zero will result in long-term interest rates below 4 percent on Treasury notes. Those low yields will look good compared to negative 20 percent returns on stocks.
John H. Makin is a resident scholar at AEI.
