If the economy withers, how can stocks bloom?

November 24, 1991|By Thomas Easton | Thomas Easton,New York Bureau of The Sun

New York -- Talk about manic behavior -- one day the stock market plunges, the next it wallows, the third it jumps and then flops. Confused?

Applying rational standards to the daily moves of share prices has always been futile. That's just as true today as earlier in the year, when war, revolutions and recession depressed everything but the market.

To grapple with the current market skittishness, analysts have produced reams of explanations. The most commonly mentioned short-term cause: Congress' ill-fated move to legally cap interest rates on credit cards. That was quickly abandoned, but it reinforced Wall Street's contempt for Washington's financial acumen.

More broadly, analysts questioned whether share prices can continue to rise while profits decline and layoffs spread. "The economy and the market are moving in different directions, and it can't last," said James McCabe, head of research at Nomura Securities, echoing a common refrain. "One has to change."

But which? And when?

In the past, the stock market has often risen despite wretched corporate profits, most notably during 1961-1962, 1970-1971, 1974-1975 and 1982-1983. Then, as now, interest rates were declining. The rational explanation is that low rates undermine the attraction of alternative investments, such as certificates of deposit, that compete with stocks for investors' dollars. And cheap money today inspires hope for more business tomorrow.

That pattern usually comes to fruition. Rate reductions not only precede recoveries but are the best single indicator of how long they last, according to Geoffrey Moore, director of Columbia University's Center for Business Cycle Research.

The correlation, however, is not perfect. Recall the 1930s. Rates began falling in 1929, but so did gross national product. A bounce in share prices in 1930 did not trigger a sustained bounce in the economy. Ultimately, both crashed.

Today, confidence in the economy's ability to support share prices appears to be waning.

Consider the opinion of securities analysts, by profession an optimistic breed. Typically, their forecasts for year-ahead corporate profits decline by one percentage point a month as reality encroaches upon hope.

"The question," said Richard Pucci, head of research at the Investment Brokers Estimate Service, "is whether they are cutting their forecasts more than normal. They have for the past two months, and that's not a good sign. If this were to keep up and snowball, people will wish the stock market remains at its current level."

So far, I/B/E/S surveys of forecasts continue to suggest analysts expect a large earnings rebound in 1992 -- something on the order of 30 percent. That's partly because 1991 results should be extremely poor, down as much as 40 percent since 1989.

It is also because the economy is expected to once again expand, after a protracted decline. The closely watched Blue Chip survey of 50 leading economists concludes growth has already begun and will continue through next year, albeit at an extremely slow rate.

But along with cutting back on the overall robustness of their forecasts, securities analysts are narrowing their perspective on what segments of the economy will do well. Earnings expectations have remained strong for companies in food processing, health care and tobacco -- presumably on the assumption people will still eat, be sick and attend to inexpensive vices.

Conversely, anything tied to consumer spending -- from automobile manufacturers to most retailers -- has been hit hard.

This change in sentiment hasn't gone unnoticed by investors, even if broad gauges of market activity such as the Dow Jones industrial average and the Standard & Poor's 500 index have only recently begun to tremble.

For example, S&P's sub-indexes for aluminum, chemical and auto companies peaked in mid-summer, just as Business Week ran a cover story entitled "A strong recovery? Yes, it's possible." The stock market seems to have concluded otherwise.

If any segment of the market is tied to the economy, it is so-called "stub stocks." They have been particularly depressed.

Stubs are the nicknames for fractions of shares that were left over from some of the highly leveraged transactions from the 1980s. Companies loaded up on debt, either voluntarily or because of acquisitions, and used the proceeds to pay off

stockholders. A few, such as FMC Corp., Harcourt Brace Jovanovich, Holiday Inns, Interco, Owens-Corning Fiberglas and USG Corp., left their shares to continue trading on the market, but these securities had little residual value.

Because of the vast debt carried by the issuing company, the amount of earnings available for shareholders, after obligatory interest payments are made to bondholders, is minimal and highly dependent on business conditions. Most of these companies have extremely low credit ratings. Under adverse circumstances, default looms.

An index of stubs compiled by the Grant's Interest Rate Observer newsletter has been an interesting gauge of economic activity and investor euphoria, exaggerating moves of the overall market.

The index soared in early 1987, disintegrated during the crash, rose again as the economy remained firm, only to crash again toward the end of last year.

Since October 1990, it has magnified the market's overall move, "caught in the froth" of a bull market, according to John Britton, a writer for Grant's.

Recently, though, it has been on the decline.

Share prices, of course, have never been predictable. But at the moment, speculation appears to be swinging away from optimism, toward fear.

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