Can Fed Rate Cut Overcome Stock Recession Nightmare?

Now comes the acid test for stocks’ bull market.

A sequence of government and private-sector reports last week described an economy slowing so drastically that a recession may be unavoidable.

The prospect of actual shrinkage of the economy--instead of the heretofore expected “soft landing” of very slow growth--clearly gave some investors pause on Friday, as the Dow Jones industrial average fell 28.36 points from Thursday’s record high to finish at 4,444.39.

But the broader market still advanced on Friday, suggesting that most investors either don’t consider the threat of recession to be real, or for their own reasons don’t believe that recession would necessarily be fatal for the bull market.

Skepticism about an official recession--defined as at least two consecutive quarters of contraction in the nation’s gross domestic product--isn’t unreasonable, of course. Government data on the economy can be dangerously misleading in the short run, and reports showing surprising weakness may later be revised upward.

What’s more, there are plenty of investors who believe that the economy’s next move isn’t as important as the Federal Reserve Board’s next move. If the Fed begins to ease credit to prop up the faltering economy, the stock market is likely to view that as inherently bullish, some Wall Streeters insist.

But if a true recession is in fact looming, can stock prices really avoid a deep pullback from their current lofty levels? History doesn’t provide a comforting answer to that question: Since 1945 there have been nine official recessions, and every one of them has been preceded or accompanied by a sharp decline in stocks.

In the typical pattern of events, stocks sell off as consumer and business spending begins to slow, because investors anticipate that corporate earnings will deteriorate. Wall Street’s slide continues until investors begin to sense that lower interest rates (the only side benefit of recession) will help spark a new economic expansion.

Last week’s economic reports provide unambiguous evidence that consumer and business activity is decelerating, and that a recession mind-set is threatening Wall Street and Main Street:

* The National Assn. of Purchasing Management, which tracks manufacturing activity nationwide, reported that its key index plummeted to 46.1% in May from 52% in April. Any index reading below 50 indicates that the manufacturing sector is contracting. The last time the index was under 50 was nearly two years ago.

* The government’s chief economic forecasting gauge, the index of leading indicators, fell for a third straight month in April, dragged down primarily by declining orders to factories. A run of three straight down months in the index has historically been a harbinger of recession.

* On Friday, the Labor Department’s report that the economy lost a net 101,000 jobs in May--the worst monthly number in four years--shocked most economists. It also stoked concerns that consumers’ confidence in their jobs and their future finances may quickly erode this summer, causing spending to slow further and thus making recession a self-fulfilling prophecy.

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“The U.S. job picture has gone from lackluster to miserable over the past two months, blowing a wide hole in the good ship Soft Landing,” said John R. Williams, chief economist at Bankers Trust Co. in New York.

Whereas the initial stages of the economy’s slowdown in January, February and March were attributed largely to a working off of excess business inventories built up during last year’s boom times, the pace of deceleration in April and May strongly suggests something more severe is afoot, said Sung Won Sohn, economist at Norwest Corp. in Minneapolis.

“If sales, production and [consumer] income continue to soften, inventories will continue to look burdensome and lead to even further trimming” by businesses, he warns. “The process is not easy to reverse once started.”

None of which is even remotely encouraging for corporate earnings, which have been surging for two years--in the process supporting the stock market during last year’s interest-rate rise and helping drive share prices to record highs this year.

With earnings now threatened by a recession at worst and a steeper-than-expected economic slowdown at best, is the 4 1/2-year-old bull market breathing its last?

Not in Jeffrey Applegate’s view. On Friday, the investment strategist for brokerage CS First Boston Corp. in New York urged clients to boost stock holdings to 60% of assets, up from 40% previously. He also suggested raising bonds to 35% of assets from 30%.

Short-term cash holdings--30% of assets in Applegate’s “model” balanced account previously--were slashed to just 5%.

What Applegate is betting on is just about the only thing the bulls can bet on now: that the Fed will begin to loosen credit, and soon.

When that happens, stock investors’ fears of economic weakness will be overwhelmed by their expectations for economic revival down the pike, keeping the bull market on track. Or so the optimists hope.

Applegate expects the Fed to reduce its benchmark short-term interest rate, the overnight federal funds rate, from 6% to 5.5% at its meeting in early July.

Indeed, the ranks of Wall Street pros who expect the Fed to cut rates in July--or even sooner--is growing daily. Norwest’s Sohn says bluntly: “The Fed should cut interest rates now.”

Perhaps more important, the bond market has virtually staked its life on a Fed cut. Longer-term bond yields, which have been sliding since December, went into a free fall in the wake of last week’s economic data. The 30-year Treasury bond yield plunged from 6.76% at the start of last week to 6.53% by Friday, the lowest yield since February, 1994.

And in a classic sign that the bond market sees a recession as a very strong possibility, the so-called yield curve now is inverted: The yield on three-month T-bills, at 5.57% on Friday, is above the yield on 2-year T-notes, at 5.55%.

Normally, longer-term interest rates are higher than short-term rates. An inverted yield curve usually means that investors expect dramatically slower growth or outright recession and are locking in long-term yields accordingly. Short-term yields stay up only until the Fed officially allows them to fall by cutting the fed funds rate.

Brokerage Salomon Bros. in New York notes that “yield curve inversions have been precursors to every major economic downturn over the past three decades.”

But with so much evidence pointing toward recession, aren’t today’s stock bulls dangerously taunting history--considering that the stock market was unable to stay afloat in advance of any other recession since 1945?

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Maybe. Unless you believe that stocks already suffered their bear mauling--in 1994. Although the Dow industrials’ peak-to-trough decline last year as interest rates rose was slightly less than 10%, the damage to many stocks was much more pronounced.

By that argument, the market in 1994 anticipated a mild recession beginning this spring, and sold off accordingly. With the recession now in gear, stocks are already looking to the next pickup in economic growth, perhaps later this year or in 1996. Hence, a new bull market is under way.

That optimistic outlook assumes a lot, however: That the recession, if we’re in one, will be relatively mild; that no external shocks will occur to deepen the economy’s woes; and that corporations, with their zeal for cost-cutting, will be able to keep any earnings decline modest and short-lived.

It also assumes that the Fed can cut short-term interest rates, with the dollar’s recent rebound still looking tenuous.

That is admittedly quite a bit to ask, and prudent investors might well wonder why they should tempt fate at this point.

Yet even some of Wall Street’s biggest bears concede that when the Fed is on the market’s side, it’s usually folly to bet against the stock market.

“Once the Fed starts easing, you get the ingredients for a bull market,” admits James Stack, the bearish publisher of the InvesTech investment newsletter in Whitefish, Mont.