Why stocks and economy diverge

Nasdaq's tumble now approaches Depression-era magnitude. Economic data point to a rebound.

America's economy and its stock market have become, for now, separate universes that are anything but parallel.

Share prices have been tumbling. A broad-based index is down 34 percent from March 2000. The tech-heavy Nasdaq index is down 72 percent – a collapse of nearly Depression-era magnitude. Some $6.8 trillion of stock wealth has vanished.

The economy, meanwhile, has been on a clear path of recovery from its mildest post-war recession. Consumers have kept spending. Incomes are rising. Even hard-hit industry has enjoyed six months of rebounding output, with a June rise announced Tuesday.

The result is an exasperating dichotomy that is extremely rare. Hardly ever do stock markets falter early in an economic recovery.

The stark – and financially devastating – disconnect stems from several unusual forces now at work.

One key explanation analysts offer is that in the late 1990s, stock prices grew into an overpriced bubble, especially in high-tech shares. This started to burst in March 2000, and it is still deflating. Investors have been fleeing stocks, especially risky ones, for the greater stability of bonds, real estate, or hard cash.

Corporate malfeasance has added to the unease. At a time when investors might otherwise be looking ahead to rebounding earnings, many instead are questioning whether quarterly financial statements can be trusted. A wave of revised earnings reports, they worry, may not be over.

"People are very worried about how these accounting scandals play out in the next few weeks," says Susan Hickok, chief economist of Prudential Economics in Newark, N.J. Second-quarter earnings will be flooding into the news in coming days.

Concerned by these troubles, some overseas investors have started to sell US stocks, helping to drive the US dollar down to parity with the euro for the first time since February 2000.

Federal Reserve chairman Alan Greenspan, in his semiannual report to Congress Tuesday, sought to soothe battered investors and worried consumers.

The effects of last year's recession, the terrorist attacks, and concerns about corporate governance "will linger for a bit longer," he said, "but as they wear off, and absent significant further adverse shocks, the US economy is posed to resume a pattern of sustainable growth."

President Bush, too, has tried to bolster the confidence of investors. "Our economy is fundamentally strong," he proclaimed at the University of Alabama, Birmingham, Monday.

But will such cheerleading, coupled with positive economic news, such as Tuesday's jump in industrial production, turn share prices around?

A debate now rages on Wall Street over whether beaten-up stocks are now a "buy" – or whether they are still overpriced. Both sides can cite statistical evidence in their favor.

Tales of divergence past

Whoever is right, stock prices can go their own way for years. For example, from February 1966 through August 1982, the Dow Jones Industrial Average slipped from 995 to 777 – 16 years of gloom broken only briefly by a high of 1052 in 1973.

Two bad recessions, and high inflation, marked that era, but the economy generally grew.

Indeed, a dichotomy between stock prices and the economy is not wholly unusual. In the last quarter of 1987, stock prices plunged more than 20 percent – about on par with this year's dive in the Standard & Poor's 500 index. Despite the pessimism on Wall Street, the economy grew nicely in 1987 and 1988.

"The correlation between the stock market and the real economy is much lower than people assume," says Jeffrey Frankel, an economist at Harvard University in Cambridge, Mass., and an expert on the business cycle.

To economists, stock prices are regarded as a "leading indicators" of the economy. A price upturn means prosperity ahead. A stock downturn warns of economic slump.

The problem: Stock prices aren't reliable as a forecaster. In December 1977, for instance, stock prices slipped 10 percent; the economy grew a handsome 5.4 percent in 1978. In 1962 stock prices fell just before the second-longest economic expansion in American history.

This year, though the bear has again been growling in the stock market, most economists anticipate 3 or 4 percent growth in the real output of goods and services. The Fed says 3.5 to 3.75 percent.

Some observers have speculated that outright panic among investors could sap confidence to the point of dragging the recovery off track. But few economists expect that to occur.

The market's "not bad enough to derail us," says David Wyss, chief economist of Standard & Poor's in New York. "The economy is doing fine."

Still, investor losses do ripple through to the larger economy. Economists calculate that for each dollar investors lose in stock values, they knock four or five cents off their purchases of goods and services. That could slash more than $300 billion out of economic growth.

A boost from real estate

But this loss is being offset by other positive factors.

House prices, for one thing, have been rising. The value of residential real estate has climbed $2.7 trillion since early 2000. Though about half of Americans own stock, mostly through retirement plans and mutual funds, a home is typically the more important investment.

"Real estate gains have neutralized the negative wealth effect from stocks, leaving the tonic of lower rates to stimulate consumer spending," notes Bruce Steinberg, chief economist of Merrill Lynch in New York.

In the past four weeks, mortgage applications have run at a record rate.

Given modest inflation, many analysts predict that Fed policymakers will certainly not raise today's extremely low interest rates in August – perhaps not for the rest of the year.

Moreover, the nation's money supply, the fuel for economic activity, has been growing at a 4.5 percent annual rate this year.

Another positive element is a stimulative fiscal situation. The federal budget has moved from a $250 billion surplus in fiscal 2000 to a $165 billion deficit for the year ending at the end of September. That $415 billion swing adds a short-term stimulus that's probably bigger than the the negative stock market "wealth effect."

Unemployment, at 5.9 percent last month, has not risen as much as in other recessions.

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