Fears on Economy Rack Wall Street
Wall Street long ago mastered the glass-is-half-empty side of the debate over the economy. Even in the best of times, the stock market is supposed to be worried.
In those rare periods when investors lose all fear of the future--as at the peak of the Internet mania--stocks can become ridiculously overvalued. And when fear becomes all-consuming, the market usually is a bargain basement.
But gauging whether investors today are too worried about the economic fundamentals or not worried enough is as tough a call as ever. It’s a call that Federal Reserve policymakers will have to make Tuesday when they gather to decide whether to take any action on interest rates.
The Fed can’t be happy to see major stock indexes tumbling back toward the multiyear lows they hit in midsummer.
The Nasdaq composite index on Thursday closed less than 1% above its five-year low, reached on Aug. 5. It rallied slightly Friday, adding 4.64 points to 1,221.09, but fell 5.4% for the week and is down 14% since Aug. 22.
The Dow Jones industrials also eked out a small gain Friday to close at 7,986.02, but lost 3.9% for the week and have surrendered most of the advance they made in late July and early August. A drop below 7,702, the four-year low reached July 23, would suggest that the bear market still hasn’t run its course, after more than 30 months.
The picture is even grimmer in Europe, where major stock indexes last week plummeted to fresh five-year lows.
And in Japan, the stock market was able to mount a midweek rally only after the Bank of Japan said it was considering becoming the buyer of last resort for troubled banks that need to unload depressed share holdings. At 9,481.08 on Friday, the Nikkei-225 index remains less than 5% above the 19-year low it hit Sept. 4.
For the Fed and other central banks, the question is whether the latest swoon in share prices is foreshadowing a slide back into recession--the dreaded “double dip.”
Many economists say that if that’s what equity markets are worried about, they’re overdoing it. At worst, the economic picture is mixed, they say.
Government data last week showed that in August U.S. housing starts dipped for a third month and industrial production fell for the first time this year.
But the National Assn. of Home Builders said its index of builder optimism rebounded this month to a two-year high, as mortgage rates have continued to decline and as buyer traffic has picked up.
Also, despite severely bearish news on corporate capital spending last week from computer services giant Electronic Data Systems--whose shares lost 53% of their value Thursday, after the company forecast a big shortfall in quarterly earnings--some analysts maintain that the corporate spending picture isn’t disastrous.
Economists warn against making an assumption that because so much of the nation’s industrial capacity sits unused, companies don’t need to make capital outlays.
The overall capacity utilization rate was 76% in August, down from a peak of more than 82% in 2000, before the recession.
But Richard Rippe, economist at Prudential Financial in New York, notes that “the question of ‘Do I need more capacity?’ is one decision. There’s also the [issue that] things wear out,” including factory equipment, computer systems, etc.
“The capital spending outlook is not as bad as advertised,” said Sung Won Sohn, economist at Wells Fargo & Co. in Minneapolis.
“Excluding structures, a lagging indicator, expenditures on equipment and software bottomed during the first quarter of this year,” Sohn said. “Outside of the aircraft and telecom sectors, equipment spending looks much healthier.”
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Earnings Outlook
To sustain spending, however, companies need decent earnings growth. And the near-term outlook for earnings may be as big a concern as any on Wall Street.
Last week, third-quarter profit warnings from McDonald’s Corp., J.P. Morgan Chase & Co. and Oracle Corp., along with EDS’ shocker, helped push more investors into the bearish camp.
So far this quarter, 457 companies have warned that earnings in the period will be lower than expected, according to data tracker Thomson First Call in Boston. That is up sharply from the 354 companies that had issued warnings at this point in the second quarter and the 359 that had warned at this point in the first quarter.
The jump in the number of companies expecting shortfalls has unnerved investors because many believed the trend was going in the other direction--that is, an improving bottom line to match an improving economy.
Wall Street analysts still expect earnings for the biggest companies, the Standard & Poor’s 500 firms, to rise this quarter from a year ago. S&P; operating earnings (results excluding one-time gains or losses) will be up 8.5% in the quarter, after a 1.4% gain in the second quarter, according to analysts’ average estimates as tracked by Thomson First Call.
Estimates for the fourth quarter peg the year-over-year growth rate at 21.3%. Many market pros believe that is far too optimistic, but if the trend in earnings just remains up, it may be enough to satisfy investors who believe this is a smarter time to be moving into stocks than out of them.
Yet the market’s price level relative to earnings continues to trouble some potential buyers.
Depending on whose numbers are used, the S&P; 500’s price-to-operating-earnings ratio based on estimated earnings for 2002 is 15 to 18. That is well below the 25-plus P/Es of the last years of the bull market, but still well above the historical average of about 13.5, and considerably above the P/Es that are typical at bear-market bottoms.
What’s more, the use of operating earnings understandably gives some investors pause because of the sense that many companies have made “one-time” charges a permanent fixture in their accounting. Likewise, more investors may prefer to rely on actual historical results instead of analysts’ estimates of what might happen.
Based on net income over the last four quarters--that is, results including all write-offs--the S&P; 500’s P/E is about 33, according to brokerage firm Lehman Bros.
Lehman’s chief investment strategist, Jeffrey Applegate, argues that stocks must be judged relative to the alternatives, particularly “cash” accounts and long-term Treasury bonds. And against those alternatives he considers stocks “very undervalued,” given the poor yields on Treasuries.
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Turning to Treasuries
Money again poured into Treasury bonds last week, driving yields to fresh 40-year lows. The 10-year T-note ended the week at 3.78%, down from 3.91% a week earlier and 4.46% on July 31.
But the continuing plunge in Treasury yields, while theoretically making stocks’ long-term prospects more alluring, also is adding to concerns about the economy. Are investors so eager to get Treasuries at any price because they’re fearful that another recession is inevitable soon, with an accompanying further collapse in stock values?
Or is the Treasury market pricing in some kind of financial-system shocker that also could have dangerous implications for the economy? Those concerns were magnified last week, when mortgage titan Fannie Mae warned of an imbalance in its assets and liabilities because so many homeowners are refinancing loans. Fannie Mae’s shares fell 11% for the week, even as the company insisted its imbalance can be easily fixed.
On Friday, nerves were jangled again as the Japanese government said its auction of new 10-year bonds failed to raise as much money as hoped, as buyers balked. Analysts called it a vote of no-confidence in a nation deep in debt and facing economic stagnation.
All of this will weigh on the Fed at Tuesday’s meeting. Yet most Fed watchers expect the central bank to leave its key short-term rate unchanged at 1.75%--sending a message to investors that the Fed believes the glass should be viewed as half full, not half empty.
Even so, economists at Goldman Sachs & Co. say the Fed must have significant concern about the events of recent weeks, including stocks’ renewed slump.
“Chairman [Alan] Greenspan is probably disappointed by the renewed darkening of commentary by senior executives, which reflects the negative surprises in profit announcements by many firms,” Goldman told clients in a note Friday. “He and his colleagues may show a rising appreciation for how the dangers of a policy mistake are far greater on the side of inadequate [monetary] stimulus.”
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Tom Petruno can be reached at tom.petruno@latimes.com.
