Stock Shock | Market's Message Is Fundamental
Szamosszegi is a fellow at the Economic Strategy Institute.
23 April 2000
The San Diego Union-Tribune
The sleep-losing dive and partial recovery in U.S. equity markets over
the past two weeks have focused this stock-crazed nation more closely
than ever on the next wave of inflation data and the Federal Reserve's
next decision on interest rates. Ironically, this drama has little to
do with the long-term health of the U.S. economy. The current valuation
of U.S. stocks is less important than the market's ability to channel
financial resources to deserving U.S. companies.
In bidding up stock prices, investors have been responding to two
interrelated developments in the real economy: the spread of
information technologies (IT) such as the Internet and the superb
performance of the U.S. macroeconomy.
Information technologies have had an enormous impact on the U.S.
economy. The statistical mosaic of America's digital economy shows that
IT has helped increase output, employment and productivity. From 1993
to 1998, real IT output accounted for one-third of U.S. real growth in
gross domestic product. Employment gains have been less spectacular,
but IT producers pay higher-than-average wages, and the wealth
generated by high-tech firms has helped to support employment
throughout the economy.
Productivity increases have been absolutely astounding. From 1990 to
1997, labor productivity among IT producers of goods and services
expanded 10 percent annually -- 23 percent among IT manufacturers.
After two decades of stagnation, the trend rate of economy-wide
productivity growth jumped from 1.5 to 2.5 percent.
The United States has also benefited from smart policies and good luck.
The Greenspan-led Federal Reserve Bank resisted pressure to raise
interest rates after the unemployment rate fell below 6 percent and
slashed U.S. interest rates after the global financial crisis of
1997-98 threatened to wash up on U.S. shores. The administration and
Congress deserve credit for maintaining fiscal discipline. As for luck,
the lower interest rates and commodity prices spawned by the crisis
offset the damage caused by weak demand for U.S. exports.
However, this exceptional economic performance does not justify current
equity valuations. The price-to-earnings ratio, which reflects how much
investors are willing to pay for each dollar of earnings, is twice the
historical norm among companies that make up the S&P 500. For many
high-flying technology companies, the ratio is meaningless because
earnings do not even exist. The Nasdaq composite index, the most
well-known barometer for technology stocks, vaulted a stunning 59
percent between November 1999 and its March 2000 peak. Other, more
complex, measures incorporating interest rates tell the same story.
The recent volatility is a strong indication that investors are
uncertain about the market's lofty levels. The dive's severity is
hardly justified by its proximate causes, the adverse decision in the
Microsoft antitrust case and the higher-than-expected inflation
reported by the March consumer price index.
Many technology firms have long complained that Microsoft's heavy hand
is holding them back. By this logic, the decision against the software
behemoth should have had other tech firms and their investors jumping
Similarly, the bad news on inflation hardly justified the rout, because the case for high inflation remains weak.
First, one month's figures hardly constitute a trend. The core
inflation rate spiked in April of 1999, but data in subsequent months
showed inflation to be in check.
Second, given the huge spike in oil prices, the jump in the CPI was not
surprising. The price of energy commodities in March 2000 was 108
percent above year-earlier levels. This increase was expected to filter
through to other sectors of the economy that consume petroleum and
related products. The question was when, not if, the increases would
begin to show up in broader price measures.
Third, data on producer prices, which measure inflation at U.S. mines,
utilities and manufacturers, was far from provocative. The core index,
which removes volatile food and energy prices, was up a scant 0.1
percent in March.
Under these circumstances, investors are right to be worried by Wall
Street's Coney Island atmosphere. Inflation remains under control, yet
within the past month, long-time market bulls, such as Goldman Sach's
Abby Joseph Cohen, have encouraged clients to reduce their technology
holdings. Journalists have exposed the accounting magic that has
inflated the revenues of many dot.com firms. Many of January's darlings
are currently at half their recent highs, even after last week's
recovery. Irrational exuberance, it seems, has been replaced by a very
rational fear that the gains of the past year could suddenly melt away.
Does it matter?
What does this new attitude mean to the U.S. economy? In the near term,
if investors repudiate the logic underlying the previous week's
carnage, they will almost certainly provide an excuse for the large
rate increase that they want to avoid. This would endanger the current
If investors are spooked by valuations and head for the exits without
any prompting from inflation, they could make life easy for the Fed. By
reducing wealth-driven spending and slowing down investment in housing
and durable equipment, the declining valuations could forestall further
rate hikes and prolong the current expansion.
Based on these scenarios, it is hard to imagine markets expanding too
far beyond their recent peaks. It is much easier to imagine the major
indexes either treading water or, in the case of the Nasdaq, suffering
through another sharp drop that encourages institutions and individuals
to invest more selectively.
Looking beyond the short term, the events of the horrific down week
were a healthy reminder that the main function of the stock market is
not to enrich its investors or to provide record ratings for CNBC. This
may be a hard pill for equity-crazed Americans to swallow, but it is
true. The market's main purpose is to channel financial resources to
activities that create economic value, and away from activities that
Herein lies the real significance of the turmoil the previous week.
Anecdotal evidence suggests that many investors view the market as a
place to get rich, not a place to invest for the long haul. With so
many people being misled into investing in firms with bogus balance
sheets or without coherent business plans, the potential for resource
misallocation has likely grown substantially along with the dot.com
bubble. For the sake of the U.S. economy, the sooner we do away with
that mindset, the better.
Nearly two years ago, a bubble pricked in a small country in Southeast
Asia led to an economic crisis of global proportions. One of the
bubble's major causes was the misallocation of resources in activities
that had little, if any, chance of economic success. Americans were
quick to criticize the people and institutions that invested without
regard for the bottom line. Until our mid-April wake-up call, the U.S.
economy seemed on the verge of traveling down that same dangerous path.
1 GRAPH; Caption: Two weeks on the Nasdaq (G-6); Credit: UNION-TRIBUNE | SOURCE: Bloomberg News