WSJ.com

The government announced Wednesday that the U.S. economy shrank at a 0.4% annual pace in the third quarter, probably heralding a recession. Yet stocks remained stable, maintaining for now their remarkable rebound since the terrorist attacks.

If the stock market's firmness holds, it's a powerful vote of confidence. Wall Street has an excellent track record of forecasting economic recovery, even when things look bleakest and companies are slashing investment and laying off workers. The bull market of the 1990s, the longest on record, began in October 1990, just two months after Iraq invaded Kuwait and five months before the recession ended.

"History tells you that by the time you have better economic news, stocks have anticipated it," says Michael Kassen, chief investment officer of mutual-fund manager Neuberger Berman LLC. His New York-based firm moved 5% of some of its balanced institutional funds from stocks into bonds in early 2000, and moved it back into stocks shortly after Sept. 11.

But the market sometimes sends false signals. Economic conditions during the past month and a half -- from an intensifying depression in capital spending to plunging consumer confidence -- give plenty of reason to suggest the post-Sept. 11 rally may be a misleading sign.

¹See the full text of the Commerce Department's report on third-quarter gross domestic product.

²Read analysis from Briefing.com on the report.

Layoffs have skyrocketed since the attacks, with many analysts expecting the Labor Department to announce Friday that the unemployment rate in October hit 5% for the first time in more than four years. Retail sales have clawed back only a portion of their post-attack plunge, as fears of job losses, possible future terrorist attacks and anthrax keep consumers skittish.

What's more, the war against terrorism has cast its own cloud of uncertainty over the U.S. Old formulas won't necessarily apply if there is another round of terrorism here or the anthrax scare widens.

With so much doubt in the air, even healthy businesses are postponing capital spending. Sales are up 55% this year at Pacific Plastics & Engineering, a Soquel, Calif.-based supplier of specialized components to the health-care industry. Chief Executive Stephanie Harkness has been hiring all year and had planned to add another 15,000 square feet to her company's 35,000-square-foot plant. But now she has decided to wait, though her company may be "bursting at the seams, and we're tripping over each other." She says she will revisit the expansion question next spring, "when we can fund it ourselves, rather than by taking on debt."

The drop in third-quarter gross domestic product was smaller than economists had expected. Many feared a decline of 1% or more. Still, it was the first such decline in eight years and the biggest in a decade. Forecasters expect a larger contraction in the fourth quarter, producing the two consecutive quarters of decline that commonly define a recession.

"It's going to get worse in the foreseeable future," says Lakshman Achuthan, managing director at the Economic Cycle Research Institute in New York. He notes that the stock market and the recent expansion of the money supply -- thanks to aggressive Federal Reserve rate cuts -- are the only significant early indicators of a turnaround. Other data -- from the number of workers making initial claims for unemployment insurance to the yields on risky bonds relative to those of safe Treasurys -- suggest a much deeper decline, he says.

And yet the stock market remains surprisingly resilient. Although the Dow Jones Industrial Average shed 46.84 points Wednesday to close at 9075.14, its third straight decline, it is still up 10% from its Sept. 21 low, as is the broader Standard & Poor's 500-stock index. The tech-laden Nasdaq Composite Index is up 19%, leaving it roughly where it was the day before the attacks.

The market's rally over the past month is important. By digesting and pricing the collective expectations of millions of individuals acting on all available information, the market is probably the most efficient leading indicator available.

In previous recessions, stocks bottomed three to nine months in advance of the economy's upturn, with an average lead time of five to six months, according to Ned Davis Research, a Venice, Fla., market-research firm. If this rally holds and the pattern is repeated, the economy should be growing again by early 2002.

That is what most economists expect. The consensus of economists tracked by the research publication Blue Chip Economic Indicators is that GDP will shrink 1.3% in the current quarter, rise slightly in the first half of next year and accelerate more strongly in the second half. If they are right, that would make this a relatively short, mild recession. The average postwar recession has lasted 11 months, according to the nonprofit National Bureau of Economic Research, in Cambridge, Mass., the most-authoritative arbiter of the business cycle.

Many stock buyers are acting on faith that the forces that have generated recoveries in the past will do so again now. There are no "fundamental signs right now that the economy is getting better," says Lynn Yturri, a portfolio manager for Bank One Corp.'s One Group Equity Income Fund. "It's all expectation that there is a big recovery waiting." Federal Reserve officials have "been doing an awesome job" laying the groundwork for recovery with interest-rate cuts, he says. And fiscal-stimulus legislation under consideration in Washington could also be key to a rebound, he adds.

Mr. Yturri says he is buying large-company growth stocks, such as McDonald's Corp., Gillette Co., Coca-Cola Co. and AOL Time Warner Inc., even though earnings projections for many of these companies are dropping. "After you lower expectations so much, they're in a position to now beat those expectations a year out or so," he says.

But the stock market can send misleading signals. During the 1973-74 bear market, the deepest since World War II, it rallied 16% before giving up those gains when the Arab oil embargo tipped the economy into a recession that lasted 16 months.

The current bear market has seen some false bottoms. The Dow climbed 21% between March and May on hopes that the Fed's interest-rate cuts would generate an economic rebound. But those hopes were buried this summer beneath an avalanche of profit disappointments.

Wednesday's GDP numbers gave few clues that a recovery is in store. Business spending on equipment, software and buildings fell at a 12% annual rate. High-tech investment dropped 14%.

Capital spending has been the economy's weak spot since the slowdown began last winter. That has aggravated the stock market's pain, since many of Wall Street's most highly valued companies are technology suppliers.

Foreigners cut their purchases of U.S. exports, but imports fell even more. That led to a slight narrowing of the trade deficit, giving U.S. producers some solace.

Businesses filled even more of their sales out of existing inventories than they did in the second quarter -- a potentially promising sign. Lean inventories mean that once sales do recover, companies will switch quickly to higher production.

Personal consumption, the economy's bulwark so far, grew just 1.2%, less than half its second-quarter rate and its slowest rate since 1993. Housing also slowed sharply. Since consumption accounts for two-thirds of GDP, it will probably determine whether in fact a recession occurs and how severe it will be.

The Sept. 11 attacks brought the economy to a near halt for several days and sent some sectors, such as tourism, into a tailspin. Activity has recovered since then but in many sectors remains well below preattack levels. Consumer confidence has fallen to a seven-year low, says the Conference Board, a New York research organization.

Ominous as the news sounds, it may portend the start of a sustained Wall Street rally. Bull markets almost always begin amid bad economic and profit news. Since 1932, years in which earnings have declined 10% or more saw an average gain of 16% by stocks, according to Ned Davis Research. Stocks typically turn up nine months before earnings do, the firm says.

And while the current round of job and capital-spending cuts are going to weigh down the economy in coming months, they are probably essential to the profit recovery stock investors are counting on.

Companies invested too much and hired too many employees during the boom. In response to those excesses, companies in the S&P 500 this year will take a record $125 billion in restructuring charges -- more than four-fifths of that by technology companies, according to Steve Galbraith, a strategist at Morgan Stanley. Recognizing the excess now could clear the way for higher profits next year. He notes that 1993 was one of the best years for profit growth on record -- and it came the year after huge restructuring charges were recorded.

Many investors now believe that stocks have fallen so far during the past two years that they must be cheap. The Dow's 30% drop between its January 2000 high and its Sept. 21, 2001, low ranks as its deepest bear market since 1987. The S&P 500's 37% drop is its steepest since 1973-74, when it fell 48%.

Patricia and Lloyd Buckwell, retired college professors in Valparaiso, Ind., have had a stash of cash sitting on the sidelines for months, waiting for the market to fall from inflated levels so they could cherry-pick stocks they have wanted to own at more reasonable levels. Recently, they bought Citigroup Inc. and Pfizer Inc. "The economy is likely to have trouble for the next six to 12 months," says Mrs. Buckwell. "But a good company is a good company."

Many big investors have reached the same conclusion. Before Sept. 11, Lois Roman, portfolio manager for the Scudder Large Company Value Fund, had a wish list of companies she wanted to buy. The attacks suddenly pushed many of the companies, in sectors such as industrial and retailing, into her target ranges. (She wouldn't name the companies.)

"The fundamentals still look terrible, and the earnings are still coming down," she says. But the stocks are at "very attractive valuations that incorporated a lot of bad news going forward."

But for all the value that stocks have lost, there is a persuasive argument that they have more room to fall. Consider price-earnings ratios: The S&P 500 is trading at 31 times trailing earnings. It is trading at between 20 and 24 times expected earnings, depending on how they are measured. Since 1929, bull markets have peaked at a P/E ratio of 17.4, on average, while bear-market troughs hit 12.5. By those measures, even in this bear market, stocks are priced well above most bull-market highs.

The temptation to buy after a big Wall Street decline is strong, says Martin Barnes, editor of the Bank Credit Analyst, a Montreal-based research publication. "But, yikes, I just wish it was priced more attractively,"

The forces that have worked so reliably in the past to power the market -- and then the economy -- may not work reliably today. That's because there are so many unusual factors at work, in particular the enormous role of capital spending.

A lot of the economic growth of the late 1990s, and the accompanying profits, went into supplying tech equipment to upstart telecom companies, dot-coms and businesses either competing with such companies or preparing for the Y2K changeover. Now many of the upstarts are gone.

The weakness in capital spending is one reason the Fed's cumulative interest-rate cut of four percentage points since January hasn't yet achieved a rebound in either growth or stocks. Business spending is less sensitive than consumer spending to interest rates. It depends more on expected sales, existing capacity, cash flow, and confidence.

Back in April, Thomas Madden, chief investment officer for U.S. stocks and high-yield bonds at Pittsburgh-based mutual-fund manager Federated Investors Inc., felt the old rules still applied. As the Fed cut rates, he had managers of funds holding a total of $860 million shift about 5% of their holdings from bonds to stocks. "If you look back on slowdowns which are consumption-led," he explains, "the Fed went to work, they restored confidence, consumer spending revived, you were back on the highway."

"We felt that the drag of the capital-spending downturn would be offset by robust consumer spending stimulated by aggressive Fed easing, and that would support corporate profits and keep the market on the boil," he adds.

Instead, capital spending fell even faster, and consumption started to weaken. So the week before the attacks, Mr. Madden shifted the money back into bonds. When the stock market tumbled anew after the terrorist attacks, he refused to move.

"My strong sense now," he says, "is that the capital spending slump is a major league affair, the type we see perhaps once in a generation."

Page One Feature

As Economic Downturn Seems to Deepen,
Market's Firmness May Signal Recovery

Page One Feature

As Economic Downturn Seems to Deepen, Market's Firmness May Signal Recovery

As Economic Downturn Seems to Deepen,
Market's Firmness May Signal Recovery