What’s in Store for the Capital Markets and the Economy?Published: September 26, 2001 in Knowledge@Wharton
In the first five trading days after the terrorist attack on the World Trade Center and Pentagon on Sept. 11, the Dow Jones Industrial Average lost 14.25%, the deepest one-week loss in 61 years. But on the following Monday, stocks jumped by 4.5%. The day after that, they initially plunged, then rebounded.
Is this the sign that stocks are near the bottom? Or will stocks resume their moves down? Will the underlying economy perk up with wartime spending or fall into recession? And if it does, will the recession be short or long?
No one knows for sure, of course. But several Wharton professors and other market watchers say history provides some guidance – if not enough to forecast the future, enough, at least, to point to the questions that must be answered before the picture becomes clearer. (Three Wharton faculty members – Jeremy J. Siegel, Robert E. Mittelstaedt, Jr. and Jerry Wind – provided their perspectives on some of these issues in the Sept. 13 edition of Knowledge@Wharton. Their analysis is available here.)
"The economy itself, and expectations about it, are what is driving the stock market right now," says Wharton finance and economics professor Richard C. Marston. "We’re basically working through our understanding of what the events of Sept. 11 are going to do to the economy."
The key, Marston says, is consumer confidence. Before Sept. 11, many of the other major supports of the economy had already weakened. Exports were shrinking and business investment had fallen. Growth in gross domestic product had fallen to an annual rate of 1%, down from 5% in the third quarter of 2000. While the Federal Reserve had tried to spur the economy by slashing short-term interest rates, the political commitment to preserve the Social Security surplus had prevented major spending, which is often used to stimulate the economy in a downturn.
But because unemployment had not grown significantly, Americans kept spending. "Remarkably enough, consumers seemed to be holding up the economy by themselves," Marston said. Whether that will continue is now very much in doubt, he said.
Indeed, the Conference Board’s widely watched monthly report revealed on Sept. 25 that consumer confidence from Sept. 1 through 18 suffered its biggest monthly drop since October 1990, when American troops were heading for the Persian Gulf. With a new military conflict apparently about to begin, it seems inconceivable that consumer confidence will quickly rebound.
"We know, in our heart of hearts, that other consumers are thinking the way we are – no new purchases," said Marston, speaking before the new Conference Board figures were released.
If consumers cut back, corporate profits shrink and companies refrain from investing in expansion. If shrinking sales force companies to lay off workers, consumer confidence is likely to fall further, prolonging the cycle.
Thomson Financial/First Call, a company which tracks analysts’ estimates, recently forecast a 22% decline in operating profits for companies in the Standard & Poor’s 500 in the quarter ending Sept. 30, compared to the same quarter a year ago. As a group, the analysts polled before the terrorist attack had expected profits to grow modestly in the fourth quarter; following the attack, they expected profits to fall.
While the typical profit downturn lasts four quarters, this one could last five – through the first quarter of 2002, Thomson concluded.
Among the uncertainties facing the economy and the markets is the impact of military conflict. Wharton banking, finance and economics professor Andrew B. Abel notes that government spending on the Vietnam War and the Great Society programs of the 1960s helped fuel the economic expansion of that era. Similarly, military spending in World War II pulled the country out of the depression.
But it is far from certain that spending on the anti-terrorist campaign will be big enough to have much effect, he said. Nor is it clear, he said, how foreign economies and financial markets will react.
"The hardest things to predict in macroeconomics are turning points," he pointed out, adding hopefully: "My guess is there’s no reason to think this recession is going to be particularly prolonged."
While it is widely believed that government spending and interest-rate cuts can stimulate an economy, these approaches don’t always work, notes Wharton finance and economics professor Franklin Allen. Japan has been trying this for a decade, with little to show for it, he said.
Much depends on the outcome of the war on terrorism, Abel added. If the campaign is quick and appears successful – if Osama bin Laden is put out of action, for instance – the American economy and stock market could bounce back the way it did after the Gulf War. But if there is a widening conflict in the Middle East, if there are more terrorist attacks in the U.S., or if the airlines are grounded again, there could be a deep and prolonged recession and stocks could fall dramatically, he said.
Despite the gloomy news, there is reason for hope. Because investors try to anticipate future events, stocks tend to rebound about six months before the economy does. If investors conclude the economy will turn around next spring, as did the analysts polled by Thomson forecast, they could start bidding stock prices up now.
In fact, a number or prominent market analysts have begun to recommend that investors put more money into stocks. On Sept. 24, Goldman, Sachs & Co. analyst Abby Joseph Cohen raised the stock portion of her model portfolio to 75% from 70%, arguing stocks could gain as much as 25% over the next 12 months.
The next day Mark Keller, chairman of the A.G. Edwards investment strategy committee, raised the recommended asset allocation to 80% from 70%, arguing that low stock prices already reflected widespread fears of recession. "Even if we get the deep recession many stock prices seem to be looking for, we doubt that such prices will decline much further," he said. "Our economic outlook, by the way, calls for no more than a mild recession."
Globally, one of the biggest concerns is the price and availability of oil, says Prudential Securities Chief Investment Strategist Greg Smith. But in a Sept. 17 letter to investors he argued that the problem is far less severe than it was during the Gulf War, when oil prices doubled. "There is a lot less concern about supply disruption since most of the moderate Arab states have committed to producing oil," he wrote.
In addition, he said, the "war" on terrorism will be quite different from a traditional war. "This will be protracted, it will be minor, we should not expect a major invasion…I don’t think we will face the same kind of events that we did in the Gulf War and I don’t think that analogy will be very useful."
Marston said recoveries can be quite sharp. Recently, he analyzed the last six major market declines -- the two oil crises of the 1970s, the recession of 1980, the crash of 1987, the Gulf War in 1990 and the Russian financial crisis of 1998.
"It’s remarkable how much the market moves up after it reaches the bottom," Marston said. The Gulf War decline dragged the Standard & Poor’s 500 down by 14.7% between June and October of 1990. But in the next six months, the index rose 25.6%. After 12 months, it had gained 33.5%. Similarly, the index dropped by 15.4% in July and August 1998, during the Russian crisis. It rose 30.3% in the following six months and 39.8% in the 12 months after the crisis ended.
Of course, that encompasses the remarkable period of the late 1990s. Presumably, investors will not regain the irrational exuberance that drove the stock bubble of 1999.
And yet, says Marston, a number of the underlying factors that made stocks good investments in the late 1990s are still in place.
Many American companies, for instance, went through tough restructurings in the 1990s, making them much more competitive. Technological improvements that helped drive productivity gains in the ‘90s can continue to drive productivity improvements in the next decade, he added.
"Coming out of the recession we will have an economy that is not broken, and we will start to get some really superior stock returns," Marston predicted.