27 Sep 2002 Please Don’t Feed the Bears – They’ve Had Enough
The third quarter is drawing to a close and almost everyone in stocks lost money. European stocks had some of their biggest losses of the past 15 years led by Europe’s largest economy, Germany. The German DAX lost 32%, the largest since its introduction in 1987. The U.K.’s FTSE 100 fell 17% for its largest loss since 1987. France’s CAC 40 fell 24%. Japan’s Nikkei 225 Stock Average declined 12% and reached a 19-year low during the third quarter. Hong Kong, South Korea and Taiwan all lost as much as 10%. Contrary to the trend, Pakistan rose 16% in response to U.S. economic sanctions being lifted. In Latin America, Argentina gained 13%, but Brazil declined 38%, the world’s worst performance for the third quarter. At home, the S&P 500 lost 14%, falling to a 4-year low and the NASDAQ fell 16.4% to a six-year low.
The major factors weighing on the market are all too familiar; impending war with Iraq, possible higher oil prices, corporate fraud, accounting malfeasance, complicit legal counsel, Wall Street analysts’ advice greedily conflicted by rich investment banking fees, and finally, extreme disappointment as expectations for a recovery in corporate earnings faded yet again. At the beginning of the quarter, analysts had estimated that third quarter S&P 500 earnings would increase by 16.6%. That estimate is now down to 7.5%.
We credit the stock market for being a leading indicator. It typically anticipates economic trends three to six months before proof comes in the form of government indicators and corporate profits. But despite its usual logical efficiency, it is always susceptible to extreme emotions, as humans comprise it. And bubbles generate historic levels of emotion. Just as the market climbed persistently higher in 2000 and 2001 in the face of mounting evidence of a slowing economy, emotions now drive it constantly lower against a backdrop of an economy that is showing signs of improvement.
The revised Gross Domestic Product for the second quarter, released this morning by the Commerce Department, shows that the U.S. economy grew at a 1.3% annual rate from April through June. GDP was reported last month as rising at a 1.1% rate. Economists expect the economy grew by three times this amount this quarter, which ends on Monday. Bloomberg quotes Bank America chief economist, Lynn Reaser who sums it up by saying “the economy has been following a seesaw pattern with strength followed by weakness. The underlying trend seems to be up, but businesses seem to be like investors, with a tremendous amount of uncertainty about the direction of the economy.” Economists polled by Bloomberg estimate growth to be 3.5% in the third quarter and 2.5% in the fourth. This year’s increase will likely be less than the average 7% growth experienced following the last nine recessions.
While the consumer keeps the economy from sinking, capital spending remains the key to its recovery. All indications are that it will be a slower recovery than previous ones. Spending on equipment and software during the second quarter rose a revised 3.3%, from 3.1% reported a month ago. This increase reflects the first increase in almost two years. But the value of spending on equipment was $961 billion, below the $990 billion spent during the second quarter of 2001. Further, business cash flow continued to decline during the second quarter, albeit at a slower rate. Funds available to corporations fell $12.6 billion compared to a $36 billion drop in the first quarter. Business fixed investment fell at a 2.4% annual rate that followed a 5.8% decrease in the first quarter. Inventories rose for the first time in 1½ years and contributed 1.3 percentage points to growth. Imports subtracted 1.4% from U.S. economic growth as they exceeded exports by $40 billion; leaving a trade deficit of $487 billion.
Yesterday, new single-family home sales were released. The report showed that August sales improved the already strong pace to another record. The 1.9% rise to a 996,000 annual rate followed a revised 977,000 pace in July, the Commerce Department said. Based on the rate so far this year, builders will sell 946,000 new homes in 2002, eclipsing the record 908,000 sold last year. Thirty-year fixed mortgage rates at the lowest in a generation are bolstering sales and keeping the economy going at a time when other industries are losing speed. Houses also represent an attractive alternative to stocks as investments because they have retained their value while stocks have declined for a third straight year.
As we leave September behind and prepare for October, we can take heart in the fact that volume on the exchanges is declining. Sellers may be running out of steam. Many stocks represent values not seen for years. There is over $5 trillion in money markets and savings accounts. Ultimately, the market’s volatility will subside and investors will begin buying up bargains in earnest. It is hard to imagine that those on the sidelines would remain in 1.5% yielding cash investments contrasted by presumably higher stock market returns.
If history is a guide we are nearing two very important periods. The November – April stock market cycle as well as the second year of a presidential cycle (the best of the four by far) together offer the majority of historical stock market returns. True, war with Iraq will likely postpone or jeopardize the market’s recovery, but the last war was surprisingly short and Iraq’s army is a fraction of the size it was then. The conflict had only a temporary impact on markets in late 1990 and early 1991. The S&P fell 17% in the two months following Iraq’s invasion of Kuwait, but by February 5, 1991 it had fully recovered its losses and continued rising another 60% before pausing in early 1994. The US economy was recovering from recession during this period as well. If history is a guide, better times for equity investors may be closer than it feels today.