Stocks Will Indicate When the Tide Is Turning

by Justin Lahart

provided by
The Wall Street Journal

During the 1990s, the U.S. stock market's ability to predict the economy was believed to trump all other forecasts. Representing the collective wisdom of millions of investors, it was seen as a near-perfect crystal ball.

After the dot-com bubble -- where shares of online travel agent soared to a higher value than those of all major U.S. airlines combined -- the market didn't seem much of an oracle. And more recently, stocks' wild swings appear more muddle than message. During the '90s, the Dow Jones Industrial Average rose or fell by 2% or more on 91 trading days. In the past year alone, there have been 80 such swings.

But in the midst of the worst economic downturn in at least a generation, a recovery in stocks would be an especially good sign.

Stocks are more than just a measure of investor expectations; they're a measure of confidence. At a time when much of what ails the economy is a crisis of confidence, when both households and businesses are so unsure of the future that they've cut spending down to the bare bones, rising stocks would be an important signal that the tide had turned. What's more, rising stocks can, in themselves, also be an important confidence booster.

The traditional view of stocks as an indicator of where the economy is going rests with the idea that investors are relentless in trying to gauge firms' profitability. "To the extent that business profitability tells you something about the economy, the stock market can provide a signal," said Columbia Business School economist Frederic Mishkin.

During nearly all 11 economic downturns since World War II, the Dow industrials have hit their recession low and begun climbing in the six months before the economy began to recover. (The big exception was the 2001 recession, where a scandal-wracked stock market didn't hit its low until nearly a year after the recovery began.) Investors are typically anxious to get into stocks ahead of the economic recovery because when stocks rally out of recessions, the gains are large.

Now, of course, many investors are just plain anxious. Since cresting in October 2007, the Dow has been halved, closing Friday at 7062.93. Current stock values no longer seem to reflect long-term profitability, Federal Reserve Chairman Ben Bernanke told the House Financial Services Committee last week, but rather "investor attitudes about risk and uncertainty, which right now are at very high levels."

Much of that is related to uncertainty about banks. Investors still don't know precisely which banks will fail or, alternatively, be taken over by the government or placed in the hands of its creditors -- any of which would wipe out shareholders. As a result, bank shares no longer reflect investors' expectations of future profits so much as bets on whether this or that bank will survive. That has made bank shares fluctuate widely, as investors struggle to figure out just what the government's approach to banks will be, and whether that approach will work. And because financial firms are at the root of the credit crisis, when they shake, the rest of the market reacts.

Last month, when Treasury Secretary Timothy Geithner offered a plan to deal with banks that investors found slim on details, the Dow industrials tumbled 4.6% in its worst day so far this year. It was an example, said Barclays Capital economist Ethan Harris, of how the stock market is becoming a barometer of how effectively policy makers are dealing with the credit crisis. Because policy is central to a recovery in the economy, a thumbs up from the stock market would be a very good sign.

A recovery in stocks could also be an important confidence builder at a time when low confidence levels are sapping the economy. "The stock market, for the average American, is the simplest way to think about the economy," Mr. Harris said. "If you see the stock market going up, you have more faith in a recovery."

Further declines, on the other hand, could endanger the economy even more. As an academic, Christina Romer, the chair of President Barack Obama's Council of Economic Advisers, argued that the stock-market collapse that began in October 1929 led uncertain consumers to sharply cut back on spending, helping to precipitate the Great Depression.

Indeed, movements in share prices tend to lead changes in consumer confidence. The conventional view has been that this happens because rising stock values make stock owners feel wealthier, or at least less poor, giving them a rosier view of the future. And at a time when many portfolios have been decimated, the effect of rising stocks on shareholders' confidence levels could be profound.

John Bollinger, head of Manhattan Beach, Calif., investment manager Bollinger Capital, says that in the office building he shares with about 50 other businesses, much of the elevator talk has been dedicated to shrinking retirement funds. "If people's 401(k)s started going up instead of down, the collective sigh of relief in this building would be huge," he said.

Even for families who don't have any skin in the stock market -- that's about half of the country -- stocks matter. A 1999 paper by Federal Reserve economist Maria Ward Otoo found that changes in stock prices affected the confidence of households surveyed for the University of Michigan's consumer-sentiment index whether or not they owned stocks. She concluded that consumers use the stock market as an indicator of where their wages are headed.

The stock market also influences corporate behavior. In a speech last month, former Fed Chairman Alan Greenspan related how in the late 1950s he found that changes in stock prices led to changes in companies' machinery orders. He recently updated the analysis and found that the relationship between stocks and corporate spending on equipment continues to hold.

"A recovery of the equity market driven largely by a receding of fear may well be a seminal turning point of the current crisis," he said. "The key issue, of course, is when."

In August 1982, during what so far ranks as the deepest downturn since the Great Depression, Mr. Greenspan's "when" came, as the Fed interest-rate cuts signaled its fight against inflation was over. Stocks rallied, and then they kept on rallying, even as bad economic news continued to pile up and some economists carped that the advance didn't make sense. That November, the recession ended.


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