How False Assumptions Caused a Real Market Dive
Is there any connection between the stock market and the real world? That question was heard loud and clear last week as stock prices gyrated wildly downward while U.S. industry continued to increase sales and profits and plans for a bright future.
The answer is, yes, there’s a connection. The market’s behavior reflects the actions of a majority of investors. But the majority is not always right--and that’s what makes stock markets and horse races and times like the present.
Investors believe interest rates are going up and that is true, so some drop in stocks is rational. But the market also seems to think inflation is accelerating and that is false, because most investors are acting on outdated information. Thus, confusion and fear rule the markets, in dramatic contrast to the real economy.
Even as stocks dropped sharply last week, the government reported that the U.S. economy grew 7% in the closing three months of 1993--the strongest quarterly showing in a decade.
And purchasing agents in Chicago said industrial production continues at a high level, with new orders setting the stage for more growth in the second and third quarter.
Companies are putting their profits to work. Eaton Corp., a truck axle maker that increased earnings 51% last year, announced that it would build a new parts plant south of Cleveland--the once depressed city that is growing again and looking forward to celebrating its 200th anniversary in 1996.
The whole Midwest is looking forward confidently, from companies like Nordson Corp., a coatings equipment maker in Westlake, Ohio, to Cummins Engine, a heavy truck engine maker in Columbus, Ind., to Giddings & Lewis, a manufacturer of computerized factory equipment in Fond du Lac, Wis.
Not only the Midwest is confident. The American Electronics Assn., in Santa Clara, Calif., predicts that its companies, which supply the computers and software and automation systems that have made U.S. industry increasingly productive, will grow 46% in the next two years to $940 billion in total sales. U.S. output in computers and related equipment was more than $500 billion last year.
It is in electronics that you’ll find the key to today’s economy and the explanation for investors’ confusion.
The computers and chips and software programs that now drive the machines of industry are not themselves rising in price. In fact, prices of computer power are falling--each new chip or program delivers more power than the last for the same or less money.
And when electronic advances are used in manufacturing plants or in truck engines or construction tractors, they allow more work to be done with less labor. That’s called productivity or progress or the power of innovation. But it is not called inflation.
Yet fears of inflation are driving stocks down because investors are missing the effect of electronics. They are assuming that if companies are producing so much, they must be reaching the limits of capacity; that if so much work is being done, wage pressures must be building up.
Investors see the growing profits in U.S. industry but they don’t make the connection to the new efficiency and productivity of that industry. So they sell on their fears.
Could their selling affect the real world by stalling out the economy’s expansion? It could, if disorder in the markets caused mortgage interest rates to rise further, shutting off housing. Or if stock prices fell dramatically enough to discourage corporate investment in new equipment.
But there is no great sign of that. Housing markets so far seem to be surviving a rise in mortgage rates. And business investment in industrial equipment is running strong--12% to 25% ahead of last year, with the fastest growth in computer related advances.
Sticks and carrots are driving such investment: the need to cut costs to keep ahead of competition, and the returns on investment in an advancing economy and in world markets that are only now awakening.
Will the stock market go back up? Markets, like life, are unpredictable and not entirely rational. Investors right now are taking profits after an almost uninterrupted three-year run-up in stock prices. Also, problems in large, speculative hedge funds are having an unsettling effect on interest rates and markets.
New fears of inflation might show up in Monday’s market after Friday’s strong report on employment, although why more Americans working should make stocks fall is a prime example of irrationality.
But the antidote to fear is knowledge. Think back to the last time the Midwest was basking in prosperity, in the 1970s. Crop and farmland prices soared, industry reported high profits and workers earned big raises. But it was all funny money. Inflation rose 10% and more per year, making an illusion of wage and profit gains and bringing disaster to the farm belt.
Curiously enough, the market saw through the illusion: The 1970s were characterized by long and dreary bear markets.
Now contrast that with today: As sales and profits rise in U.S. industry, labor costs are going up less than 1% a year. Overall inflation is rising 2.8% on an annual basis and even medical inflation is now under 6% after more than a decade of double-digit growth.
Credit electronics for that, says economist William Finan of Technecon Analytic Research, a Washington consulting firm that specializes in the electronics industry. “We are the deflationary engine,” he says.
Finan believes the market underestimates electronics’ effect because U.S. government statistics don’t really capture the industry’s falling prices. Computer prices alone fell 30% last year, he reckons.
When the majority of investors realize the implications of that in the real world of U.S. industry, the stock market may rise again.
