Cyclical Realities: Wall St. Grapples With the Downside

As technology stocks’ swoon deepened in October and November, some of the investors fleeing that holy mess found refuge in a much simpler business concept: bleach.

Shares of Clorox Co., the maker of the famous bleach and many other household products (charcoal, Glad bags, salad dressings and more), surged 38% from mid-September to late-November, a run-up that coincided with a 22% slide in the tech-dominated Nasdaq composite stock index.

Classic Wall Street theory fueled that split performance: If tech stocks still were richly valued, while spending on tech equipment was slowing with the weakening economy, there was a high likelihood of more pain ahead for that sector. By contrast, even in a struggling economy people still would need bleach to keep their clothes clean and Glad bags to keep their bologna sandwiches fresh.

Or would they? Thursday, the day that Microsoft Corp. joined the ever-lengthening list of tech firms warning of weaker-than-expected earnings ahead, Clorox also dropped a bomb: It said sales this quarter will decline from the year-ago period, slashing profit. The Oakland company’s shares skidded 27% for the week to end Friday at $30.06, a nine-month low.

Somewhat amusing, unless you’re a Clorox shareholder, was that the company in part blamed its sales troubles on “an unprecedented number of vacancies” among its managerial ranks, as key staffers left over the last year or so to join Bay Area Internet companies.

But Clorox also said it has been surprised by how sharply consumers have cut back on cleaning product purchases in recent months, as spending in general has slowed.

Clorox’s problems may well be unique among makers of so-called consumer-staple products. But if its warning is echoed by rivals in coming weeks and months, it will fit the time-honored pattern of the economy and the stock market when boom gives way to something less fun: People will look for places to hide, but hiding places will become increasingly scarce.

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In an economic slowdown, Wall Street’s game at first turns “defensive”: Many investors initially sell the stocks of companies that are most vulnerable as business and consumer spending weakens. Rather than leave the market entirely, however, investors turn to shares of companies that are unlikely, or less likely, to be affected by the slowdown.

Traditionally, those defensive sectors have included household-product makers, food companies and drug companies, because many or most consumers don’t stop cleaning their homes, eating, or taking medicine, even if they do stop buying homes, cars or computers.

If the economy’s downturn deepens, however, even classic defensive sectors can begin to be squeezed as people watch their wallets much more carefully.

The stocks in those sectors, in turn, are more at risk because their prices have been pushed up as investors have rushed into them, hoping for safe haven--i.e., the Clorox example.

There will always be companies that will manage to escape even severe economic slumps relatively unscathed, but investors understandably become less willing to take a chance on even those stocks as concerns over the economy mount.

That mentality appeared to be dominant last week, as 16 of 19 U.S. stock mutual fund categories tracked by Morningstar Inc. fell. The average domestic stock fund slid 4.2% for the week, putting the year-to-date decline at 3.2%.

On Friday, another painful market sell-off drove the Nasdaq composite as low as 2,596 by midday, though it rebounded to close at 2,653.27, off 9.1% for the week and down 34.8% year-to-date.

The blue-chip Standard & Poor’s 500 index also rebounded from its worst levels Friday, but still closed at a new 52-week low, at 1,312.15. It lost 4.2% for the week and is off 10.7% year-to-date.

Investors may be getting used to disappointment this year, but many probably still were unprepared to see stocks fall even as the presidential election battle came to an end, with Wall Street’s clear favorite, George W. Bush, as the victor.

What’s more, the conventional wisdom a few weeks ago was that further signs of economic weakness would be good for stocks, because the evidence would compel the Federal Reserve to act faster to loosen credit and keep a slowdown from spiraling into a recession.

So far, that bad-news-is-good-news concept isn’t holding much water with the investors who are making buy-and-sell decisions on a daily basis. Even so, there remains the chance that the Fed, at its policy meeting Tuesday, will go beyond what’s already expected--removal of the central bank’s inflation-worry “bias”--and make some statement that strongly indicates that interest rate cuts are coming in 2001.

If the Fed does go the extra yard in trying to calm investors, but the market refuses to climb out of its funk even then, hope for the long-awaited year-end rally may all but evaporate.

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If Wall Street can’t find its mojo any time soon, suspicions will rise that the market is foretelling a full-blown recession--the feared “hard landing” for the economy.

The market, of course, can and does get these things wrong. When it does, it makes for an excellent buying opportunity for investors with guts and patience.

That was the case in September 1998, when investors pummeled U.S. stocks, thinking that Russia’s debt woes would trigger a global financial-system implosion. It didn’t happen, in part because the U.S. economy was so strong, and in part because the Fed rode to the rescue, cutting short-term interest rates three times in rapid succession.

If, however, the market is correctly foreshadowing that spending by businesses and consumers alike is in the process of an extended pullback, the question becomes whether share prices as yet reflect the full impact of that pullback on corporate profits.

There are some very good reasons to believe that profits, even without an official recession (which is two consecutive quarters of shrinking gross domestic product), will be under pressure for most of next year. And profits, remember, are what ultimately underpin stock prices.

Goldman Sachs & Co. economist Ed McKelvey recently cut his estimate for profit growth in the U.S. corporate sector overall to a mere 2.5% in 2001, down from an expected 11% this year.

McKelvey sees problems on three fronts. First, he says, labor productivity is likely to decelerate with a weakening economy--which is what has happened historically.

Second, he sees workers pressuring companies for higher wage increases, in part because of the large jump in energy costs that people are being forced to bear (think gasoline and home-heating costs).

Third, the corporate borrowing binge of recent years, and the probability that many companies will have to fund their capital-spending budgets for 2001 with more borrowed funds, will mean that burdensome interest bills will continue for many firms, unless the Fed slashes rates.

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The closer investors are to the stock market, and the larger the nest egg they have at stake, the challenge at times like this is to remind oneself that markets, and the economy, are forever cyclical. In other words, we’ve been here before.

In the economy, fast growth gives way to slower growth and, sometimes to recession. Eventually, though, fast growth returns, and with it a surge in corporate profits.

In the stock market, bull markets give way to relatively modest pullbacks (“corrections”) and sometimes to bear markets. Eventually, many stocks (though certainly not all) rebound.

The accompanying chart is one I trot out annually, generally when things are either very bad, or very good, on Wall Street. With nine words, the chart sums up the path of the market’s cycle, and the emotions that dominate at each stage of the cycle, from boom to bust.

It’s clear in retrospect that tech stocks were peaking in March, because so many investors had absolute conviction about the stocks even at their wildly inflated prices--and because greed was driving those who weren’t in the shares to get in.

Today, the tech stock curve seems to be somewhere in the vicinity of “concern” and “capitulation” on the chart. We may not have hit bottom, but we’re probably closer to it than to the peak.

The broader market is a tougher call; it will only become clearer as we see in 2001 just how much of a struggle the economy faces.

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Tom Petruno can be reached at tom.petruno@latimes.com.