The Economic Outlook for 2003: A Promising StartPublished: January 15, 2003 in Knowledge@Wharton
Last year marked the first time in decades that the U.S. stock market had logged three losing years in a row. Will 2003 be better?
So far, the signs are encouraging. The Standard & Poor’s 500 rose nearly 6% in the first nine trading days. Historically, the start of January has been a good indicator of full-year performance, though there have been plenty of exceptions.
The possibility of war, the continuing sluggishness of the economy, excess production capacity and debate over President Bush’s $674 billion tax-cut package hang over the market. “The economy looks like it’s going to move along,” says Wharton finance professor Marshall Blume, echoing a widely held view that recovery is taking hold. “Stock prices will move along, too. We’ll probably have some inflationary pressure, but not much.”
After three years of falling prices, stocks are no longer overpriced, he says. The price-to-earnings ratio for the S&P 500 has fallen to below 20, based on earnings estimates for the next 12 months, compared to more than 30 when stocks peaked in March 2000. The historical average is around 15, but many experts think that low interest rates, low dividend yields and other factors make a level of around 20 the norm today.
“It’s always hard to predict where the stock market is going to go,” Blume notes. “But the stock market, assuming you buy it at a reasonable price, tracks earnings. And if earnings go up, stocks will go up … All the forecasts say earnings per share are going to go up. They’re not going to go up [very fast], but they are going to go up.”
A survey of 54 economists by the newsletter Blue Chip Economic Indicators found most expect corporate profits to rise 8% during the year. That would be the biggest increase in five years. The economists said economic activity will pick up as the year progresses, due to stimulation from government military spending and a decrease in the “risk aversion” that has held back spending by businesses. The economy should expand at a 2.7% annual rate in the first quarter, compared to a 2.4% rate in 2002, with the rate rising to 3.8% in the fourth quarter, those surveyed said.
Stronger economic growth will push interest rates up, and the economists predicted the Fed Funds rate will rise from today’s 1.25% to 2.13% by the end of the year. They project unemployment to fall from the current 6% level to about 5.7% in the fourth quarter.
Richard Marston, professor of finance and economics at Wharton, cautions that forecasts often prove wrong, noting that a December survey by Barron’s found six of seven forecasters at top securities firms had predicted at the start of 2002 that the S&P 500 would rise by year end. The positive predictions ranged from a small 4.5% gain to a stunning 36.8%. In fact, the index fell 23.4%. Only the Bank of America analyst was anywhere close, having predicted a drop of 17.3%.
“It was a complete surprise – what happened in 2002,” Marston says. Most experts had thought the market declines of 2000 and 2001 had wrung out with the excesses from the tech bubble of the late 1990s. But forecasters could not predict the series of corporate scandals that rocked the market in 2002.
“Through the spring it was just one company after another, and it got uglier and uglier,” he notes. “The accumulation just overwhelmed investors. I think WorldCom was the straw that broke investors’ backs.” Nonetheless, Marston adds, the stock market does tend to rise when investors anticipate a recovery that has not yet arrived.
During the last four recessions, the S&P 500 hit bottom several months before the recession ended, then followed with big gains. After bottoming out in the 1990-91 recession, for instance, the index gained 27.8% in the following six months and 29.1% in the 12 months after the low point. This doesn’t necessarily suggest the market is headed for stupendous gains in 2003, however. The S&P 500 has already gained about 20% since hitting a five-year low Oct. 9.
Many forecasters say the possibility of war with Iraq is holding the market back despite the improving economic outlook. Consumers, credited with keeping the economy together by continuing to spend during the past few years, are still doing so, and military spending by the government will help.
“What we don’t have,” says Marston, “is any turnaround in [business] investment, and we’re waiting for it. I don’t think that’s going to occur during this war uncertainty.” Many business leaders will hold off for fear of a spike in oil prices, he predicts. Adds Blume: “The war itself is not the risk. It’s really the effect of oil on corporate earnings.”
According to Marston, if there is not an oil crisis, the economy could enter “a traditional, full-fledged recovery” in the third quarter. He recalls that the S&P 500 fell about 15% in the two months after the Iraqi invasion of Kuwait in August 1990, but that it had regained all those losses, and continued higher, before President Bush declared a cease fire at the end of February 1991. “I see the [stock] market turning around sometime this year. I think it’s going to be the result of some indication that the economy is turning around,” Marston says. But “interest rates are going to rise. We know that.” And rising rates are likely to hammer bond prices.
President Bush has added a new element to the mix with his $674 billion tax-cut proposal, centering on elimination of the income tax investors pay on dividends. Such a move would make dividend-paying stocks more profitable for investors, and the proposal has already helped boost stock prices, says Andrew Metrick, finance professor at Wharton. If Congress adopts the measure, stocks will further benefit; if it is defeated or scaled back to only a partial tax exemption, stocks may suffer, he suggests.
Most experts agree that the president’s proposal is not so much a short-term stimulus as a long-term reform that could benefit the economy and financial markets in years to come. Still, some worry that such a major tax cut, if it is not matched by spending cuts, could make the federal budget deficit large enough to damage the economy.
“Adding a large, long-term deficit, which is what this risks doing, could have a very serious impact on long-term interest rates and seriously hurt investments,” says finance professor Joao Gomes. “It does seem like a very dangerous path.”
Investors also have not gotten over their worry about corporate misdeeds, says Metrick. “I think the big question on everybody’s mind is, what other shoes are going to drop?”
The new accounting oversight board does not yet have a chairman and will take months to begin formulating rules to deal with the problems exposed by Enron and the other scandals. And it’s too soon, Metrick says, to judge how well various corporate-governance reforms enacted last year will work. “Companies have become a lot more complicated over the past five years and corporate disclosure hasn’t kept up,” he points out. “Do we really know everything about these companies? If we go a year without any huge WorldCom-level scandal, I think that will be pretty positive for the stock market.” But, he cautions, there is always a chance some new problem will undermine investor sentiment.
Most analysts have been aware, he notes, that plunging stock prices have undermined many pension plans. But they were still surprised when General Motors disclosed earlier this month that costs to shore up its under-funded pension plan would triple, reducing profits by 26%. Says Metrick: “I don’t think that anyone knows the full extent of the problem.”