Market’s Out of the Blocks--but Too Soon
Why is the stock market going up while the economy is flat on its back?
Because investor enthusiasm has gotten a little ahead of economic reality. Pretty soon, stock prices will come down some--not a crash, just a retreat--and after that they’ll be able to build on a more solid base.
To recap the story so far, the stock market has climbed dramatically since the end of April, to hit new highs for the Dow Jones industrial index and Standard & Poor’s 500 index. (On Tuesday, the Dow Jones index fell 10.19 to 2,925, in what market experts called only a pause in the upward movement.)
Small investors are helping the rally, in what could be the beginning of a trend. Money is pouring into equity mutual funds as individual investors say stocks are good bets for retirement savings. “Deferred gratification is in,” says Michael Hines, a vice president of Fidelity Investments mutual fund group, “saving for retirement is investors’ No. 1 objective these days.”
In fact, the T. Rowe Price mutual fund group recently offered potential customers a retirement planning kit and had many takers under 40 among 175,000 respondents.
Meanwhile, it has been a case of seeing silver linings for the big pension fund investors, who account for most of the trading in stocks. The pros see interest rates coming down because the economy is so slow.
Slow is an understatement. There was no real growth in employment last month, and employers are cautious in their outlook for hiring in the summer and early fall. Housing construction and housing sales are down, and so are factory orders and the government’s leading indicators of future economic activity.
So what’s with the stock market? Too much, too soon. Small investors buying equity funds are on to a good idea long term, but short term the economy’s weakness will lead to disappointments--even for the pros who think lower interest rates will instantly spur business activity.
Business is slow because of self-doubt, not because interest rates are holding it back. “The borrowers are as reluctant as the lenders,” explains Charles Clough, chief investment strategist of Merrill Lynch. “That’s why commercial borrowing grew only 2% last year.” Banks are cutting back on loans, especially to real estate developers; bank examiners are tightening standards on loans, and small-business borrowing is at the lowest levels in more than a decade. The result is a slowdown.
Banker Thomas C. Frost, chairman of San Antonio-based Cullen/Frost Bankers, understands what’s happening around the country because it happened in Texas in the 1980s. “Business people lose confidence in their ability to predict the future,” says Frost, 62. “So borrowers reckon, ‘I better not expand;’ lenders reckon, ‘I better not lend,’ and the bank examiners say, ‘You better hold back.’ ”
What happens then? “You change your objectives,” says Frost, whose bank was founded by his great-grandfather. “You get more realistic.” Cullen/Frost went from more than $200 million in loans in 1984 to $152 million as of last year. It also reduced deposits and staff and expenses for furniture. It shrank its business and posted more reserves for loan losses. But what it has left is sound business: The bank’s profit is growing again as the Texas economy recovers.
Now, to be sure, the U.S. economy is not facing a decade of depression as Texas just did. The national economy is more diverse and stronger; it’s not even in recession.
But it could get close. The aftermath of the debt explosion of the 1980s is being wrung out of the U.S. economy--as witness failed savings and loans, the pressure on many banks and widespread troubles in commercial real estate. It’s a time of credit contraction, not expansion.
What does that mean for the stock market? Just this: It’s hard for an economy to grow fast without expanding credit. Yet many of today’s stock prices are based on expectations of rapidly growing earnings.
To take a typical example, Procter & Gamble is selling at more than $82 a share--which works out to 18 times P&G;’s per-share earnings in the fiscal year ending June 30 and 16 times what analysts project as its earnings a year from now. The current price represents a high hurdle for P&G;, and if its earnings come up short of analysts’ expectations--as well they might in a slow economy--the stock price could adjust downward, perhaps to $70 or $65 a share, a 15% to 20% drop.
Make such an adjustment for the whole stock market, and the Dow Jones average retreats to 2,400-2,500 from levels over 2,900. If such a fall occurs in a single day, it’s a Crash. But if it happens over several months, it’s a bear market--or a retreat to a more solid base for growth in the new decade.
For long term, the outlook is good--for the U.S. economy and for the stock market. Already strength is evident in export industries. Eaton Corp., a big Cleveland-based industrial supplier, reports growing sales to U.S. exporters, even as domestic business slows.
And all those people saving for retirement will be a big plus for the economy. “No question in my mind,” says author and money manager Kenneth Fisher, “the ‘90s are going to be an American decade.”
Great expectations may be justified, in short, but investors might find patience a useful virtue too.
