Is Wall St. Sending an Ominous Signal?

The last time the U.S. stock market fell three years in a row, the Axis powers were overrunning the planet.

The time before that, it was the early years of the Great Depression.

Now the market has done it again, losing ground for three straight calendar years for the first time in a generation.

Beyond the obvious financial pain to tens of millions of investors in this extended decline, there is the question of whether it also holds a dire message: Is the stock market warning that something is, or soon will be, terribly wrong with the economy?

Or are Wall Street’s problems largely its own -- the continuing deflating of the unprecedented market bubble of the late 1990s?

Experts are deeply divided over what, if anything, the market is saying about the bigger picture. That’s because the role of stocks as an economic forecasting mechanism has long been both celebrated and panned. An old joke is that Wall Street has correctly predicted 12 of the last six recessions.

For big and small investors alike, judging what the market may be trying to signal has taken on more importance as share prices have stumbled again in recent weeks, after a bounce from five-year lows in October.

December, historically a positive month for stocks as investors look to the new year, was a bust. The blue-chip Standard & Poor’s 500 index dropped 6% for the month, extending the loss for the year to 23%. That followed price declines of 13% in 2001 and 10% in 2000.

For investors like Charles Jones of Calabasas, the market continues to telegraph a simple message: Stay away, and be worried.

Jones, 63, says he has been hoping for a sustained rally to signal that it’s time to commit new money to stocks. Instead, with prices sagging again, and with the United States and Iraq seemingly on a collision course, Jones says he will keep shoveling any new savings into money market accounts.

“I’m just not comfortable sticking more money in stocks right now,” he said. Although money market fund yields are below 1%, “at least I won’t lose it” there, he said.

It’s possible, of course, that Jones and other fearful investors will have missed a huge opportunity to buy stocks at deeply depressed levels if prices zoom in 2003. But their reluctance to jump in is understandable given the market’s continuing struggles. Wall Street is hardly exuding great confidence about the future.

The predictive abilities of the market have always been the subject of heated debate. Still, major shifts in share prices have frequently foretold major shifts in the economy.

That was the case from 1929 to 1932, as a relentless decline on Wall Street spoke of a depression of massive scale. Similarly, the Japanese stock market’s prolonged slide since 1990 has coincided with that economy’s downward spiral.

More recently, Wall Street’s decline beginning in March 2000 foreshadowed the end of the 1990s economic boom, even though a recession didn’t officially begin until the first quarter of 2001.

On the flip side, in 1982 a powerful stock rally accurately foretold an economic recovery and the end of an era of high inflation, even though many investors at first were incredulous.

Why should the market have an ability to see the future? In theory, the collective financial decisions of millions of investors large and small reflect all relevant information at any given moment.

So if investors sense that the economic outlook is deteriorating, and thus that corporate earnings are likely to be poor, they would be more inclined to sell stocks than to buy them -- driving the market lower.

If the collective sense is that the economy is improving, investors would be expected to be buyers of shares, because stocks are the easiest way to take part in a business recovery.

Either way, the market’s trend also can greatly influence the economy through the “wealth effect”: As investors feel poorer, or richer, the market can create its own economic weather.

This time, however, U.S. economic growth has been positive for five quarters, through December. Profits of the big-name companies in the Standard & Poor’s 500 index also have been rebounding, on the whole, since the second quarter of last year, after five straight quarterly declines, according to data tracker Thomson First Call.

Yet stocks have waned.

“I’m in the camp that says this is mostly a market problem,” said Scott Grannis, economist at Western Asset Management in Pasadena. “There is no looming economic disaster. We’re just kind of poking along.”

Federal Reserve Chairman Alan Greenspan has suggested much the same thing. Despite weak consumer spending in recent months, and the still- cautious outlook of many businesses, “our best judgment is that we’re going through a soft patch” in the economy but are not headed for a “far more significant weakening,” Greenspan told Congress in mid-November.

James Glassman, economist at J.P. Morgan Securities in New York, argues that “every positive thing the economy had going for it in the 1990s is still in place,” including strong gains in worker productivity, low inflation and rising personal income.

“Not only are we not doing so badly, but we’re doing better than everybody else,” primarily meaning Europe and Japan, Glassman said. He predicts that the U.S. economy will grow at a real rate of 3.5% in 2003, up from an estimated 3% in 2002, helped by continuing low interest rates and by expected federal tax cuts.

“Washington has religion -- they all know they have to get the economy moving this year,” he said.

Then why haven’t stocks been able to mount a convincing rally, if the market is supposed to anticipate better times?

Many experts say the issue is simply that share prices, despite their deep declines during the last three years, have only returned to a “fair” level, at best, relative to underlying corporate earnings.

At the height of the bull market, “stock valuations were inflated to levels beyond anything since the 1920s,” said Ned Riley, investment strategist at money manager State Street Global Advisors in Boston. “So a lot of the retrenchment of the market has been purely a function of that overdone, irrational euphoria.”

In other words, even in- vestors who believe that the economy and thus corporate profits are back on a decent growth track are nervous about overpaying for stocks, given the harsh lessons of the bear market.

That is why, over the last year, “the things that would normally rally the market didn’t,” Riley said -- for example, the Federal Reserve-engineered decline in short-term interest rates to 40-year lows.

What’s more, even though many companies’ earnings reports began to improve in the second quarter of last year, “investors wondered whether the numbers meant anything” amid the rash of accounting scandals, Riley said.

He, for one, is bullish about 2003. After three years of lower stock prices, “I would suggest we have narrowed the gap dramatically between the reality of the economy and the reality of the market.”

Still, Riley and other market pros acknowledge that the geopolitical threats to the economy -- the potential for a U.S.-Iraq war, a conflict with North Korea and more terrorist attacks on U.S. soil -- are giving many investors pause.

On that count, it’s possible that the stock market, so far unable to break out of its funk, is foretelling that geopolitical disasters will drive the economy back into recession in 2003.

A plunge in the dollar’s value in recent weeks and a surge in gold prices also appear to reflect rising fears among investors worldwide about the next major move in the economy. Gold, the traditional safe-haven investment, is trading near $348 an ounce, the highest level in more than five years.

One measure of the fear level among American investors is the massive inflow of cash into basic bank savings accounts in the last two years.

Although the interest paid on those accounts typically is less than 1%, they now hold more than $2.7 trillion, up from $1.7 trillion at the beginning of 2000, according to Federal Reserve data.

By contrast, assets in stock mutual funds have shrunk to about $2.8 trillion now from $4 trillion three years ago.

Analysts at the Jerome Levy Forecasting Center, an economic research firm in Mt. Kisco, N.Y., believe that the stock market may have a better sense of what’s to come than most economists.

“Industrial production, retail sales and employment have all slipped from their highs during the last few months,” suggesting that the economic recovery may be ending, the center told clients in a recent report.

David A. Levy, chairman of the center, contends that the probability of a recession by mid- 2003 is about 60%, even if there is no war with Iraq.

Levy is in the minority among market professionals. But many believe that, at a minimum, Wall Street’s poor performance foreshadows a period that won’t be anything like the boom years of the late 1990s.

“I think it’s telling us that the economy is going to be in a more sluggish mode,” said Tim Hayes, stock strategist at Ned Davis Research in Nokomis, Fla.

The time to become worried that there’s a more desperate message in the market, he said, would be “if we have another big decline from here.”