Date: Mon, 7 Feb 2000 16:18:51 -0500 (EST) From: Rakesh Bhandari <bhandari at phoenix.Princeton.EDU>
Abreast of the Market
How a Drop in Stocks Could Slam the Economy By Greg Ip
02/07/2000 The Wall Street Journal Page C1
Investors usually thank the remarkable economic boom, which last week became the longest in U.S. history, for making the bull market in stocks possible.But maybe it is the economy that should be thanking the bull market instead.
In a reversal of how most investors have viewed the situation, soaring stocks appear to be driving many of the positive economic forces at work, rather than the other way around. They have stoked consumer spending, padded corporate profits, kept a lid on inflation and chipped away at the budget deficit. So here is a disturbing thought: If the market falls, do these factors switch into reverse -- further undermining stocks, in a vicious spiral?
"Despite the positive impact of technology on our economy and financial markets, we have a bit of a Ponzi scheme going here," William Gross, chief investment officer of Pacific Investment Management Co., wrote this past fall. In other words, "At least some of our prosperity is based upon prosperity itself."
The traditional view is that economic factors drive stocks, not vice versa. But then, the stock market has never been as big a part of Americans' lives -- or so exuberant -- as it is now. Last week, the Federal Reserve Board raised interest rates one-quarter of a percentage point and hinted more increases would come, but stocks enjoyed yet another positive week. The Dow Jones Industrial Average, which fell 49.64 Friday, or 0.45%, to 10963.80, ended the week up 224.93 points, or 2.1%. The Nasdaq Composite Index, which rose 33.16 points Friday to a record 4244.14, rallied 9.2% on the week.
Robust consumer spending has been the bulwark of the economic boom, but a lot of that consumption is coming out of investors' stock winnings. Indeed, Fed Chairman Alan Greenspan says this "wealth effect" is estimated to have contributed a percentage point of the 4% annual growth in gross domestic product since late 1996.
What happens if this wealth effect goes into reverse? Consider that when stocks corrected in the fall of both 1998 and 1999, consumer confidence took a hit. When stocks rebounded in both of the following Januarys, so did confidence.
"The stock market has played a large role in the spending binge that's going on," says Mark McClellan, a senior editor at Bank Credit Analyst Research Group in Montreal. If and when stocks correct, "you'll get a retrenchment in the household sector. Once people realize they can't get 20% on stocks year after year, they'll finally realize, `Hey, I have to save a little bit to reach my retirement goals.'"
Hunkered-down consumers won't do much for Wal-Mart Stores' profits. Perhaps Microsoft and General Electric don't have to worry as much, but then slumping stocks will do different damage to their profits. They and many other companies have booked hundreds of millions of dollars in profits by selling stakes in Internetrelated start-ups. Should the Internet stock sector deflate, so will the opportunity to repeat those large profits.
In addition, some big, mature companies like Lucent Technologies have enjoyed windfall stock gains in their employee pension plans, enabling them to book pension income instead of expense. Without that pension benefit, profits of Standard & Poor's 500-stock index companies would have been 3% lower in 1998, Bear Stearns estimates. Falling stocks will squeeze that income, as well, though it would take awhile to show up. To be sure, these are small factors in the overall profit picture, but they won't do much to restore confidence in stocks.
Even if the stock market takes the wind out of consumer spending and profits, it should have the benefit of easing some of the demand-driven pressure on wages and prices, enabling the Fed to cut interest rates. But there might be a perverse countertrend. The stock market has actually helped in several ways keep a lid on price and wage increases, a contribution that might disappear in a bear market.
For example, many companies have substituted stock options for wage increases. A team of Fed economists figure employment costs, which grew 3.1% from 1994 to 1998, would have grown 3.4% if options were included.
The beauty of performance-based pay like options, of course, is that when times are tough, companies can reduce their labor bills without layoffs. At such times, employees usually agree to put job security ahead of wage gains. On the other hand, it's also possible, especially in the Internet-related sector, that "employees who are working in companies expecting big checks from options, will say, `I'll leave the clicks and go to the bricks, where it may be less money but at least I'll get it,'" says Chris Varvares, an economist at Macroeconomic Advisors in St. Louis. If so, to keep valued employees, some companies will be forced to replace their worthless options with cash.
Even with higher costs, companies may not be able to raise prices, given how fierce competition now is, especially from Internet competitors. But a stock slump might actually restore some pricing power. Many start-up companies can sell books, drugs and personal computers at a loss over the Web thanks to cash infusions from initial public offerings of stock or venturecapital funds, forcing traditional competitors to match. When red-ink-soaked Amazon.com started selling bestsellers for 50% off, Barnes & Noble's online affiliate had to match.
If these upstarts disappear, will traditional competitors try to raise pricesmuch as big airlines do once a discount airline abandons a route? One example: Low-end personal computer prices have risen in recent months, as some moneylosing vendors were forced to stop giving away PCs or selling super-inexpensive models.
A falling stock market could also weaken the dollar, whose strength against the euro is highly correlated with stocks. Trevor Greetham, global strategist at Merrill Lynch, says a rising Dow Jones Industrial Average lifts the dollar both because foreigners are buying U.S. stocks and because it suggests the U.S. business sector is a good place to invest. Conversely, "Whenever the Dow slumps you get a big drop in the dollar."
So if stocks go into a protracted decline, so might the dollar -- removing one of the factors that has kept imports inexpensive and limited the ability of U.S. companies to raise prices. "It does have an impact at the margin on inflationary pressures," says Mr. Greetham, adding, "The Fed wouldn't be keen to see a weakening dollar while oil prices are rising."
Even the budget surplus, which has helped hold down bond yields as last week's Treasury buyback announcement demonstrated, could be eroded by a bear market. Since 1994, when the bull market's most powerful phase began, the Congressional Budget Office estimates the federal government's capital-gains-tax take almost tripled to an estimated $100 billion last year. That increase is equal to half the $124 billion fiscal 1999 surplus. A 20% drop in stocks would still leave investors with enormous paper profits, but the Treasury would nonetheless see an important source of revenue start to shrink.
Taking these factors together, it is possible to imagine a falling stock market weakening the economy and cutting profits, but at the same time putting upward pressure on inflation and interest rates -- further undermining stocks. This would clearly be the opposite of historical experience, where a weak economy paves the way for lower inflation and interest rates and, eventually, a rallying stock market.
But both the market and the economy have broken a lot of the old rules on the way up. They might break some rules on the way down, as well.