Stocks Are Wildcard in Economic Slowdown

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Saturday July 28 8:30 AM ET

Stocks Are Wildcard in Economic Slowdown

By Pierre Belec

NEW YORK (Reuters) - A lot of companies are going through hard times and many have lost their compasses, unable to tell the direction of their earnings because the economy is too unstable to make a precise forecast. And it could be another year before they find their way again.

The big question being asked by stock market investors who are feeling lost and tired after months of gut-wrenching market action: Why have the rapid-fire cuts in interest rates by the Federal Reserve (news - web sites) not primed the economy and stocks?

Each of the six cuts by the Fed since January has sparked snappy but brief market rallies, only to fizzle. Stocks are now back at April's lows.

The best explanation for this unresponsive reaction to the Fed's rate rescue is that this isn't your typical economic downturn, says Allen Sinai, chief global economist for Decision Economics.

``The normal linkages between lower interest rates, the economy and increased corporate earnings have been broken,'' he says. ``What's happening is that the economy is in an unconventional recession that is being caused primarily by Corporate America.''

As a result, the stock market is not behaving the way it should under the favorable interest-rate environment.

``Whenever there's been a business cycle reversed, as we now have in the United States, any efforts by the Federal Reserve to correct a slowdown problem have not worked quickly,'' he says.

Since the first week of January, the Fed has slashed interest rates six times, knocking down the federal funds rate on overnight loans among banks by 2.75 percentage points to a seven-year low of 3.75 percent, fueling expectations that the lower cost of borrowing by this credit-dependent nation will pump more life into the sluggish economy. The speculation is the central bank may lower yet again at its Aug. 21 policy-setting meeting.

MARKET STUCK IN ROUGH, COMPANIES IN SAND TRAP

Yet, against the background of this freer money, the market is still stuck in the rough and corporate profits are in a sand trap, in what may shape up to be the worst earnings year in a decade.

How does the central bank work the economy? The Fed basically ``leans against the winds'' of inflation and economic stagnation, says Paul Kasriel, director of economic research for Northern Trust Co.

In normal business cycles, the Fed raises interest rates, as it did between 1999 and 2000, which depresses housing and personal consumption of big-ticket items like cars. Businesses cut back on their inventories and lay off workers. At the end of the food chain, are businesses, which cut back on capital spending on things that make companies run more efficiently.

On the flip side, once the Fed stimulates growth by lowering interest rates, it can reverse a downturn in housing and personal consumption, and spur businesses to rev up spending on capital spending.

But a monkey wrench has been thrown into the works. The United States is going through an upside-down type of slowdown or a near-recession. Housing and personal spending have so far held up nicely unlike in other downturns, but the drag on the economy is coming from capital spending by businesses. That third leg holding up the economy usually falls the last.

``The business sector is the driving force this time, cutting back on production, inventories, capital spending, especially for technology,'' Sinai says. ``But because the downturn is from the business sector, which doesn't react as vigorously to cheaper interest rates, there are no guarantees that lower rates will work in the traditional way.''

The reason is that only two things can really power business spending: expectations of future sales and earnings, not interest rates. Right now, businesses don't have much confidence in the future after the economy turned in its weakest performance in eight years during the second quarter.

Fed Chairman Alan Greenspan (news - web sites) again dropped hints this week that people should not expect the rapid-fire rate-cutting to be the magic cure for the slowing economy.

In testimony to the Senate Banking Committee, he warned there were still considerable risks that the economy may get worse before it gets better.

If things weren't bad enough, it looks like half of the world's economies are heading into recession, which will mean less demand for American-made goods. The Europeans, for instance, are getting hit from all side with demand falling from overseas as well as at home.

With about half of the companies in the Standard & Poor's 500 having reported earnings, analysts expect second-quarter results to be down about 18 percent, according to research firm Thomson Financial/First Call.

The truth is that analysts were blindsided by the speed of the economy's fall. A year ago, no one was forecasting a downturn in corporate profits. The 2001 earnings are on course to be the worst since the last recession in 1990-91.

What has been happening is that earnings have deteriorated so fast that Wall Street is having a tough time pricing the bad news. The first quarter was supposed to mark the end of the ugly earnings season. Now that the second quarter has brought more ugly results, there's a drumbeat of gloomy comments that things won't get better until late this year or mid-2002.

WORST THING TO FEAR: MULTIPLIER EFFECT

The reality is that the economy is susceptible to contagion. Call it the multiplier effect.

As companies earn less money, they fire workers and the jump in the jobless rate slows personal income, leading to less consumer spending, which ultimately slams corporate earnings. This in turns pounds stocks lower, making Americans who invest in the stock market feel poor, i.e. reverse the wealth effect.

Consumer confidence is already starting shaky. A key measure of U.S. consumer confidence (news - web sites) dipped in July as Americans said their current financial picture deteriorated due to big corporate layoffs and a flat stock market.

The University of Michigan's July consumer sentiment index edged down to 92.4 from 92.6 in June, but was well above a five-year low of 90.6 struck in February.

Sinai says the biggest risk to consumer spending is job losses. And the threat grows larger every day with companies unveiling lousy earnings and rushing to pull the job-cutting lever to improve the next quarters.

Job cuts by U.S. companies jumped 56 percent in June, according to the outplacement firm Challenger, Gray & Christmas, rising to 124,852 from 80,140 in May. It was the sixth time in seven months that planned job cuts totaled more than 100,000.

Also, not much hiring is going on and the earliest signs of a recovery are months away.

``There's no reason to expect companies to hire people until at least October or November when corporate planning goes into gear and CEOs will look at how the year 2002 shapes up,'' Sinai says.

``I expect that corporate executives will sit on their hands and it's very possible they will reach the conclusion that there should be further work force cuts,'' he says.

The inability of business spending to respond quickly to easier money was shown this week as Lucent Technologies Inc. (NYSE:LU - news), the former king of the telecommunications equipment market, revisited the emergency room and took $7 billion to $9 billion in new restructuring charges. It also mailed out another 15,000 to 20,000 layoff notices, in addition to the 19,000 cuts early this year. Lucent's head count will total less than half the 155,000 employees it had just a year ago.

Lucent, which is in talks with banks to avoid debt default, has been crushed by its customers' massive cutbacks on telecom gears as businesses sit out the economic slowdown.

DuPont Co.(NYSE:DD - news), the largest U.S. chemical maker, lost money in the second quarter and increased job cuts by 1,500 from the number targeted in the spring to 5,500. It also warned that things would not improve in the third quarter as the economic downturn continued to hurt demand for chemicals.

NOW, ALMOST GOOD NEWS

``Business cycle downturns are self-healing,'' Sinai says. ''If you do nothing about it, then the illness will go away eventually, but by lowering rates, the Fed can hasten the recovery.''

Sinai's bet: Because the economic slowdown is business-driven, the economy could stay weak for at least 18 months from the date of the first rate cut by the Fed back in January.

Will the champagne corks pop in the second half of 2002?

For the week, the Dow Jones industrial average was down 160 points at 10,416. The Nasdaq composite index was unchanged at 2,029 and the Standard & Poor's 500 index dipped 5 points to 1,205.

-- (M@rket.trends), July 28, 2001


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