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NOW WE KNOW THAT stocks really do go down as well as up, don't we? But wait a minute. Aren't horrific market days like Monday's 554-point drop in the Dow supposed to be a thing of the past? Bad things aren't supposed to be happening anymore, at least not to those of us in the United States. The message is abroad in the land that we've entered the New Economy, an endless financial summer warmed by technology, globalization and rising productivity. Don't worry, be happy.
This increasingly popular view has it that economic expansions can go on almost indefinitely without touching off inflation. But even if you believe that everything is for the best in this best of all possible worlds, that still doesn't mean stocks will go up indefinitely. A strong economy doesn't necessarily make for a strong stock market. And when you look below the surface, you find even the most Panglossian New Era types are actually hedging their optimistic long-term projections with plenty of warnings and equivocations and quibbles.
The market is vulnerable to air-pocket-type drops that appear out of nowhere because the prices of even many of the biggest, most widely held blue-chip stocks are based on the smiley-face view of the economy: profits will rise, and interest rates and inflation fall, forever. So any bad news, real or imagined, hits particularly hard. On Monday, Asia's spreading woes touched off selling that took on a life of its own. You think the 8.2 percent one-day drop in IBM to $90 from $98 was a rational response to worries about the prospect of lower profits from IBM's operations in Malaysia, Hong Kong, Taiwan and Thailand? Or that Tuesday's rise to $99.375 meant that investors had rationally reconsidered? Did the rise have something to do with IBM's announcement Tuesday that some time in the future, maybe, it will buy back $3.5 billion of stock? And was any- one paying attention to the fact that the company still had more than $1 billion left to go on its previously announced buyback? You think 498 of Standard & Poor's 500 Index stocks fell on Monday because 498 companies' prospects had simultaneously dimmed? Yeah, right.
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Monday's sharp fall--let's avoid the word ""correction,'' which implies that having your investments decline in value is good--didn't end America's newfound fascination with the market, which despite last week's fall has almost doubled since the start of 1995. Public interest in the market was much greater during Monday's 7.2 percent drop than during the truly awful 22.6 percent crash in October of 1987. You can see why. Lots more people are in the market now, thanks to the increase in 401(k) retirement plans, the spread of stock options and the spectacular market rise that has lured all sorts of new players. Talk about stocks being mainstream. Maria Bartiromo of CNBC, the cable-TV financial-news network, was the first guest on David Letterman's show Tuesday night. What more do you need to know?
These market neophytes aren't the only ones who have fallen under the sway of New Paradigm optimism. After all, lots of supposedly serious and important people think the Social Security system can be rescued by putting trust-fund money into stocks. Many people have forgotten that stocks don't always rise. And I'm not even talking about the horrible bear market that lasted from the fall of 1973 through the summer of 1982, or even about the drop in 1990. Stocks were strictly blahville as recently as 1994, when the Dow was up slightly for the year, Standard & Poor's 500 Index down slightly.
But among the smiley-face crowd, 1994 is ancient history, the concern only of doddering old fossils and Old Era mossbacks who don't understand how wonderful the world has become. After all, we're in a New Era, aren't we? And isn't there a New Paradigm? And aren't wealth and prosperity guaranteed?
Well, no. Even if the New Era-ists are right and the rules about how long the economy can keep growing without setting off inflation have changed, which could well be, a long-term upward trend doesn't mean there won't be plenty of downs in between. Stock prices have trended up since the New York Stock Exchange was founded 205 years ago, but there have been long periods when stocks have been crummy investments. You have to be around long enough for the long-term trend to help you. In the immortal words of the late, great economist John Maynard Keynes, ""In the long run we are all dead.''
If you have a working knowledge of economic history, you know that the four most dangerous words in the English language are, ""This time, it's different.'' That's because things are almost never different; about the time you think the world has really changed, it turns around and bites you. But some very smart people like Deutsche Morgan Grenfell's chief economist, Ed Yardeni, who has a real grasp of history, contend that things really are different now. The New Era argument, as propounded by Yardeni, one of its earliest and loudest advocates, goes something like this: the end of the cold war, gains in productivity created by increased computerization and advances in communications and manufacturing technology have changed the old rules, in which economic cycles in the United States ran three to five years from bust to boom to bust. The United States is happily making the transition from a war economy, which lasted from World War II through the collapse of the Soviet Union, to a peace economy. War economies are high inflation, peace economies are low inflation.
It used to be, Yardeni holds, that the United States would emerge from recession, then wages would start to rise faster than increases in worker output, companies would raise prices, inflation would appear and the Fed would take away the punch bowl by raising interest rates high enough to cool off the economy. But now, Yardeni says, the world is so interconnected that it's hard for companies in the United States (or any place with relatively free trade) to raise prices without attracting competition from the rest of the world. International competition squeezes salaries and prices, keeping inflation at bay and removing the need for the Fed to raise interest rates to keep the economy from overheating. The United States, with the world's best-trained and most flexible supply of workers and entrepreneurs, can grow far more rapidly than during the long cold-war period because we can sell to the entire world, not just to customers in he United States.
But Yardeni is no blind optimist. If you actually read to the end of what he writes or spend more than five minutes talking to him, you discover that while he's a long-term bull, he's a very wary one. Not an endless-summer guy at all. ""You think I'm an idiot?'' he asks. ""I'm flexible, I adapt to what's going on, I don't just say one thing and stick to it blindly. I'm a New Era economist, not a Golden Era economist.'' Yardeni is now telling his clients he believes the stock market's bullish days are numbered, that bonds are a better buy than stocks for now, that there's a 40 percent chance of a recession in the year 2000 and that some time before then, individual investors are likely to start selling during market declines, which will exacerbate the selling panic. Doesn't sound like Mr. Sunshine, does he?
Then there's the case of two other bulls, Peter Schwartz and Peter Leyden, authors of an influential Wired magazine cover story titled ""The Long Boom: A History of the Future, 1980-2020.'' But let's look past the mindlessly optimistic headline and see what Schwartz and Leyden actually wrote. Ooops. After 18 pages of cheerleading about why things will get better and better, you find the following: ""This is only a scenario of the future, by no means an outright prediction of what is to come.'' In other words, maybe we'll have an endless boom. Then again, maybe we won't. I'm not blaming Schwartz and Leyden for hedging--they'd be fools if they didn't. It's just that in this case, as in many of the other cases I looked at, the cover or headline or sound bite tells you one thing, the full text is something quite different.
It would be much easier to criticize New Era thinking if you could find someone of standing who preaches the gospel without equivocation. However, we couldn't find anyone like that. Even MIT economist Paul Krugman, who's written many interesting critiques of New Economy thinking, doesn't attack individuals by name. No big-time New Era folks are foolish enough to ignore the lessons of history and predict that the world will be sunny forever. But that's how their thinking has been transmuted in the popular mind.
The one thing that Yardeni and the Old Era types agree on is that the next problem we may face in the United States is deflation--falling prices--rather than inflation. That's because the world is awash in surplus capacity for all sorts of things ranging from computer chips to cars to textiles. Asian manufacturers who borrowed dollars to finance expansion and are stuck with depreciating local currencies and weakening local economies are going to try to sell more stuff here. Ditto for Latin America, which is starting to show distressing signs of coming under the same pressures that have racked Asia since Thailand devalued its currency last summer. Deflation is great for consumers but not so good for lenders, corporations or workers. It would also be bad for stocks, because corporate profits would shrivel. Society as a whole would benefit, but companies wouldn't.
If deflation is severe and protracted, it could be as bad as hyperinflation, because it could cause a wave of personal and corporate bankruptcies and bank collapses, as people are unable to pay their bills. It could also touch off a sharp economic contraction, which has happened to some extent in Japan, and could happen in parts of Asia, though probably not in the United States.
But while long-term deflation is bad for stockholders and creditors, it's fabulous for bondholders. That's because interest rates would fall, increasing the value of bonds with higher-than-market interest rates. Take Japan, where interest rates, the economy and the stock market have all fallen since late 1989, when the Nikkei 225 index peaked at a tad under 39,000. At the Nikkei's Friday close of 16,459, stocks are down 58 percent (in yen) from their peak. Property values and interest rates have fallen sharply, too. But bondholders are happy. According to Goldman, Sachs, someone who bought a 10-year Japanese government bond on Jan. 1, 1990, and kept a constant 10-year average maturity by swapping into new bonds has made 83 percent in interest and capital gains. That's lots better than owning the Nikkei, which is down about 50 percent since 1990 even after including reinvested dividends.
No one knows what will happen next in the U.S. market. Conventional wisdom is frequently wrong. The 1987 market crash spawned predictions that a recession was imminent. It wasn't. Japan was supposedly destined to rule the world in the 1980s just as the oil-exporting nations were supposed to rule the world in the 1970s and the United States was supposed to be on the way to repealing the business cycle once before, in the 1960s. None of that happened. There are plenty of other examples, but you get the point.
And let's put things in perspective. Even with last week's crummy performance, the stock market has still done fine this year. The Dow is up 15 percent, while Standard & Poor's 500 Index is up 25 percent. (Most of that big difference, says David Braverman of Standard & Poor, comes from the fact that banks and technology stocks, both of which are up very sharply this year, represent more than 30 percent of the S&P 500 but only 14 percent of the Dow.)
After watching the stock markets here and overseas move wildly almost every day for a week and a half, the thought occurs that maybe there is a New Era after all. But of a different sort. Markets used to take years to boom and bust. Now, thanks to globalization, we can go through the entire cycle in two days.
U.S. exports to Asia Percentage of total exports, Jan.-Aug. 1997 China 1.7% Hong Kong 2.2% Indonesia 0.7% Japan 9.9% S. Korea 3.9% Philippines 1.1% Singapore 2.6% Taiwan 2.9% Thailand 1.1%
Source: Census Bureau.
Nov. 1948-0ct. 1949 As the U.S. economy throttles down for peacetime, production contracts sharply. Even a boom in spending by returning GIs isn't enough to offset this 'demand shock.'
July 1953-May 1954 The Korean War produces a boom that overheats the economy. Factories run at full tilt, unemployment falls and the government clamps down.
Aug. 1957-Aprii 1958 Another boom-driven recession. America's love affair with the auto sets plants humming again. As inflation hits a stunning 5.9%, the Fed tightens- and stays tight.
April 1960-Feb. 1961 A double whammy: the steel strike of 1959 is a major 'supply shock'; a 'demand shock' comes from Ike's balanced budget of 1960, which reduces federal spending.
Dec. 1969-Nov. 1910 The Vietnam War sends the inflation rate up. LBJ raises taxes, and the Fed clamps down on credit.
Nov. 1973-March 1915 The lifting of Nixon's wage and price controls causes inflation to soar. And OPEC delivers the first oil shock, quadrupling the price of crude.
Jan. 1980-July 1980 Turmoil in Iran causes oil prices to soar again, sending the inflation rate into double digits. Carter imposes credit controls, which causes consumer spending to contract.
July 1681-Nov. 1982 As in the 1980 recession, the Fed's Paul Volcker is determined to strangle inflation, which has hit stunning levels, by tightening up on the money supply. He keeps money tight well into the downturn, which is long and severe.
July 1998-March 1991 A long period of easy credit budds a realestate bubble. Banks and S&Ls tank. Then Saddam Hussein invades Kuwait, raising oil prices.
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