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As Downturn Deepens, Stocks Point to Recovery

The government announced Wednesday that the U.S. economy shrank at a 0.4% annual pace in the third quarter, probably heralding a recession. Yet stocks remained stable, maintaining for now their remarkable rebound since the terrorist attacks.

Which of the two signals predicts where the economy is heading?

If the stock market's firmness holds, it's a powerful vote of confidence. Wall Street has an excellent track record of forecasting economic recovery, even when things look bleakest and companies are slashing investment and laying off workers. The bull market of the 1990s, the longest on record, began in October 1990, just two months after Iraq invaded Kuwait and five months before the recession ended.

"History tells you that by the time you have better economic news, stocks have anticipated it," says Michael Kassen, chief investment officer of mutual-fund manager Neuberger Berman LLC. His New York-based firm moved 5% of some of its balanced institutional funds from stocks into bonds in early 2000, and moved it back into stocks shortly after Sept. 11.

False Signals

But the market sometimes sends false signals. Economic conditions during the past month and a half -- from an intensifying depression in capital spending to plunging consumer confidence -- give plenty of reason to suggest the post-Sept. 11 rally may be a misleading sign.

Layoffs have skyrocketed since the attacks, with many analysts expecting the Labor Department to announce Friday that the unemployment rate in October hit 5% for the first time in more than four years. Retail sales have clawed back only a portion of their post-attack plunge, as fears of job losses, possible future terrorist attacks and anthrax keep consumers skittish.

What's more, the war against terrorism has cast its own cloud of uncertainty over the U.S. Old formulas won't necessarily apply if there is another round of terrorism here or the anthrax scare widens.

With so much doubt in the air, even healthy businesses are postponing capital spending. Sales are up 55% this year at Pacific Plastics & Engineering, a Soquel, Calif.-based supplier of specialized components to the health-care industry. Chief Executive Stephanie Harkness has been hiring all year and had planned to add another 15,000 square feet to her company's 35,000-square-foot plant. But now she has decided to wait, though her company may be "bursting at the seams, and we're tripping over each other." She says she will revisit the expansion question next spring, "when we can fund it ourselves, rather than by taking on debt."

More Contraction

The drop in third-quarter gross domestic product was smaller than economists had expected. Many feared a decline of 1% or more. Still, it was the first such decline in eight years and the biggest in a decade. Forecasters expect a larger contraction in the fourth quarter, producing the two consecutive quarters of decline that commonly define a recession.

"It's going to get worse in the foreseeable future," says Lakshman Achuthan, managing director at the Economic Cycle Research Institute in New York. He notes that the stock market and the recent expansion of the money supply -- thanks to aggressive Federal Reserve rate cuts -- are the only significant early indicators of a turnaround. Other data suggest a deeper decline, he says....