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The traditional sequence of events on Wall Street is for the Federal
Reserve to call the economy’s tune, with the stock and bond markets
discounting what will eventually occur on Main Street. As we now know,
the Fed’s ability to alter the course of the economy is not as
great as it once was. Moreover, its monetary strategy was greatly changed
by the events of 9/11. The easing that took place after the attack on
America created tremendous liquidity and reduced the Fed’s discount
rate from 3.0% to 1.25% within one quarter! This was earlier than the
Fed had planned for. Treasury bond yields, which had been falling since
mid 2000 (6.15%) continued their descent (to 4.2%) until last year’s
fourth quarter stock market rally. It was at this time that bondholders
began to worry that a full-blown recovery was about to unfold. Interest
rates began to rise until early April when they peaked at 5.42% (coincident
with the intermediate top of the stock market). Then, as the S&P
500 reasserted its downtrend, bond yields declined again. In other words,
the bond market was taking its cue from the stock market. The positive
correlation between stock prices and bond yields has been quite eye-catching
(See Chart 1). This is the
opposite of the past twenty-five years (through 1998) when there was
a negative correlation. The question is: Has Main Street been
taking its cue from Wall Street rather than the other way around?
We believe that the poor short-term economic results reported for July
and August reflect an unusual circumstance. That is to say, Wall Street
is impacting Main Street to a much greater degree than is usual. The
sharp drop in equity values that occurred in July put both consumers
and corporate executives into a “do nothing” mode. With much
of the discussion about an economic “double-dip” now appearing
in the press, we are reminded of the Fats Waller tune titled “Jitterbug
Waltz”. (A Jitterbug was dance fashioned after the Lindy Hop, made
famous at the Savoy Ballroom in Harlem. In this dance style, the lead
can change from one partner to the other and “double dipping”
was common.) Two recent economic reports could suggest that a double
dip might be forthcoming. First is the Philadelphia Federal Reserve’s
Business Outlook Survey. The New Order portion of the index (See
Chart 2) has recovered from the low levels of
2001, but it has recently turned down and was a surprisingly low number
for August. We use a three-month moving average to smooth this diffusion
index. We would point out that the volatility of this index is quite
high and that this turn of events does not engender a second deep dip.
The second index of concern is the University of Michigan Index of Consumer
Confidence. (See Chart 3) It
too has turned down in concert with the stock market. However, significant
volatility was observed from this index during the three years after
the 1990 recession. Thus consumer sentiment can be a volatile and sometimes
misleading indicator of future business trends.
Unfortunately, there are other confirming signs of a new slowdown. The
Conference Board and the Economic Cycle Research Institute both report
that their leading indicators are drifting downward. Much of this change
has to do with the dramatic drop in the stock market last month. As
it turns out, the stock market has become an even more critical variable
in determining consumer (and corporate) spending trends. In our commentary
of a year ago (see
The Thrill Is Gone!), we forecast an upward migration in the savings
rate. It now appears likely that the consumer savings rate will reach
6-7%, up from the low of 2% a year ago and the current reading of 4.2%.
As one can see in Chart 4,
there is a good relationship between the inverted wealth ratio (income/net
worth) and the savings rate (savings/disposable personal income). During
the second quarter, savings increased by 118%! This is not the kind
of environment that makes for a consumer-lead recovery. If the stock
market is the new driver of the economy, then a return to reasonable
valuations (18 times earnings) would be very helpful for the economy.
However, the S&P 500 has already rallied 17% from its lows, and
we suspect that there needs to be additional backing-and-filling before
a sustainable sideways channel is recognized.
We have no illusions that the economic recovery will be swift or robust.
Once investors regain confidence in corporate managements and earnings
begin to accelerate, we may see the jitterbugs change partners again.
And Main Street will once again lead Wall Street.
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John
K. Dolan
Brian
E. Schaefer
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S&P
500: 963
August 22, 2002
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