In the 10 days after the Sept. 11 terrorist attacks, the stock market plunged nearly 12%. Then it turned around, racking up a stunning 19% gain by the end of the year.

Market experts have long held that stocks anticipate economic events by about six months. According to this view, the autumn and early winter gains reflected investors’ belief that the economy would pull out of the recession in the spring of 2002.

While there is some debate over whether the economy was truly in a recession last year – gross domestic product definitely fell for one quarter but perhaps not for two – a recovery is clearly under way now. For the quarter ended March 31, GDP surged at a blistering 5.8% annual pace, the fastest rate since late 1999. GDP had grown at a sluggish 1.7% rate in the fourth quarter of 2001. The economy shrank in the second quarter of 2001, and perhaps in the third quarter as well.

But stocks, rather than continuing last year’s rise, have turned downward again. The Standard & Poor’s 500 is off approximately 8.5% this year, having given up about half the gains enjoyed at the end of 2001. Stocks fell even after the first quarter’s strong GDP figures were reported late in April.

What, then, is the market saying about the next six months? And what does the economic data suggest? “I think we’ve got a good setting now for recovery,” said Lawrence Klein, emeritus professor of economics and finance at Wharton and the University of Pennsylvania, and winner of the Nobel Memorial Prize in Economic Sciences in 1980. But, he adds, some of the elements of a robust recovery have yet to fall into place. Growth for the rest of year will probably be slow. “We’re still lacking a follow-through in business spending and investment.”

Having built up spending and investment in the late 1990s, only to be burned by the downturn of the past two years, businesses are especially cautious about pumping up investment again, he said. Consumers appear to have overcome post-9/11 concerns, he added, but businesses still harbor fears about the potential economic effects of war or another terrorist attack. “For the businessman who has to plan risky investments for the next 10 years, [those fears] haven’t worn off.”

According to Klein, a number of factors kept last year’s economic downturn mild, making recovery easier. In the latter part of 2001, production declined as business drew down inventories, but consumer spending was healthy. Auto sales, for example, jumped to around 20 million units in October, compared to 16 or 17 million in a typical month, as dealers offered zero percent financing. Those deals helped soften the recession.

In addition, he said, last year’s federal tax rebates kicked in just as the economy needed stimulation after the terrorist attacks. “The rebates were quite powerful.” And in the months since 9/11, government spending on the military has also stimulated the economy. “We have now what I call military Keynesianism,” Klein said. “Like it or not, that’s going to be a strong point for the economy. It played a significant role in the [GNP] figures that were reported for the first quarter of 2002.”

Another key to the economy is the residential housing market, where sales held up because of low mortgage rates, Klein pointed out. Furthermore, with many inventories dramatically reduced by the end of last year and consumers still demanding products, companies boosted production early in this year, accounting for the dramatic GDP figure reported last month, he said.

Then on May 7, the Labor Department reported that productivity rose at a stunning 8.6% annual rate in the first quarter, the most dramatic figure since 1983. Productivity rose because output increased while employment and wages did not. In fact, unemployment has inched up to 6%, from 5.7% early in the year. With inflation and interest rates at historically low levels, “I think we’ve got a good setting now for recovery,” Klein predicted.

Productivity gains mean companies can improve profits without raising prices, which would trigger inflation. Citing the lack of inflation threats, the Federal Reserve announced May 7 that it would continue its low-interest rate policy. Most analysts don’t expect a rate hike before August.

Despite some good economic news, Klein said he doubts that the first quarter’s economic growth will be repeated, given the shortage of business spending. For the current quarter and the next two, he expects GDP to grow at an annualized rate of 2 to 3%. The Fed, too, warned it is “still uncertain” that consumer demand will continue to strengthen.”

Consumer spending grew at an annual rate of 3.5% in the first quarter. While that was a good sign, many economists focused on the fact that spending had grown by 6.1% in the prior quarter. Any sign of a fall off is worrisome.

Wharton finance professor Jeremy Siegel agrees that GDP is not likely to grow at the first quarter’s torrid pace for the rest of the year. Once the depleted inventories are restored, there will be less need to ramp up production. “No one expects it to,” he said. “I think we’re probably going to settle at 3 to 3 ½% growth in this quarter, and I think it’s very possible to reach 4% in the last two quarters of the year.”

Consumer demand, he added, is not growing fast enough to stimulate anything more than modest gains in the stock market. “The truth of the matter is that we’re basically seeing that demand is growing in the middle single-digits numbers. The market is expecting earnings growth of 8, 10, 12%, and it’s very hard to generate that off of single-digit [sales] volume growth.

“I think the stock market might have more trouble than the economy, because profits are going to be hard to come by,” Siegel noted, adding that investors remain skittish and have thus not jumped back into stocks with great enthusiasm, despite the improving economy. All the major market indexes are well below their highs of two years ago. The record highs of early 2000 were caused by the bubble in tech stocks. Despite the losses of the past two years, stocks are not cheap today by historical standards.

At around 1050, the Standard & Poor’s 500 is trading at about 20 times analysts’ projected earnings for the next 12 months, according to Siegel. “I think that right now that’s a fair market valuation. It’s not real cheap, but not at all overpriced or too expensive …That doesn’t mean we can’t get more undervalued if investors get discouraged at the pace of growth of corporate profits.” The stock market is quite fragile and could fall considerably with a shock like another terrorist attack, he said.


The stock market, Siegel added, “is really a wild card.” If stocks were to fall dramatically, consumer spending could shrink, pulling one of the legs out from under the economic recovery.


Stocks, he predicted, are likely to offer nominal (before inflation) returns of 7 to 9% a year, far less than they did in the 1990s, but still much better than the returns offered by bonds and cash. After factoring in inflation, he added, real returns could average 5 to 7% for the next five or perhaps 10 years.