I am fortunate to have enjoyed Ron Howard's film, A Beautiful Mind, before I came across A.O. Scott's review of it in The New York Times. Scott is very concerned about the factual disconnect between the actual life of Nobel Prize mathematician John Forbes Nash Jr. and the considerably more noble version portrayed so ably by Russell Crowe on the silver screen.
I was quite content to have been stirred and inspired by the story, being only vaguely aware that a real person's life had inspired the emotional tale. But the Times' critic does raise a valid issue concerning the importance of differentiating between real and pretend. The substance of Nash's story, both his real one and the Hollywood version, is that this important distinction is not always easy to make.
According to Nash's biographer, Sylvia Nasar, all mathematicians live in two different worlds. One is a theoretical world of perfect and predictable relationships discovered and enjoyed by a gifted elite. The other, of course, is the sensate world where "life creeps by in its petty pace from day to day." The real world we mortals inhabit-a world of conflicts, uncertainty and ceaseless ambiguity. Nash, despite or perhaps because of his beautiful mind, did not negotiate this great divide as well as others. To commute back and forth between the theoretical and the real is a challenge, it occurred to me, not unlike that experienced by those of us who earn our daily bread by interpreting the securities markets for lay people.
We study the laws of economics, ingest the corollaries of modern portfolio theory, analyze the dictums of CPAs and parse the pronouncements of talking heads. We expect, and more significantly, our clients expect, that diligence with respect to this data will produce an understanding of the fundamental relationship, say, between economic growth and securities prices. We evidently believe that these expectations are grounded in "reality" because we accept compensation in return for our pronouncements. But does the reality we perceive in our theoretical world translate smoothly to the nitty-gritty reality of the marketplace?
Business Cycle Realities
Take for example, our understanding of the business cycle. We all realize that the sum of the goods and services produced by all Americans (GDP) does not grow at a steady rate year in and year out. Rather, it grows faster than average for a while, then it grows more slowly or even shrinks for a while. When it shrinks for six months, we call it a recession. We call the whole period from one recession to the next a business cycle.
The "real" or inflation-adjusted GDP growth rate is primarily a function of two inputs-labor force growth and productivity growth. Each of these tends to run in the 1% to 2% territory, giving us a roughly 2% to 4% realistic expectation for GDP growth over time. Sometimes the nation's output will accelerate to a 5% or 6% rate of growth for short stretches. This happens when our farms and factories produce more than the market requires or when consumers take on extra debt to increase their purchases. In theory, at least, both of these are temporary stimulants. Market forces tend to correct them, resulting in slower than average GDP growth or a recession that endures until an equilibrium of sorts is regained.
For something like 65 years, every cyclical downturn has had similar characteristics. To wit, output approaches the limits of efficient capacity, inflation accelerates, the central bank dampens demand with restrictive credit policies, inventories rise relative to final demand, and eventually GDP recedes until inventory and credit excesses are corrected. Then the Federal Reserve loosens the reins, demand starts to pick up, and a new cycle begins. This has been our "reality" for about three generations.
Then along comes the recession of 2001. The Fed raises rates, GDP slows to an arctic 0% to 1% for nine months, excess inventories are cleared out, the Fed cuts short-term interest rates like crazy, stock prices begin to rise, and the economy stabilizes. We check our theoretical reality, match it up with historic data and it looks like we're already into another up cycle. Right? Well, maybe, maybe not.
At first glance, the behavior of inventories and the actions of the Fed may look like every other cycle. But on closer inspection, we see what may turn out to be significant variations on the familiar recession theme; variations that could make near-term economic activity look quite different from the traditional recovery pattern that the stock market seems to be expecting.
For openers, the United States entered the recent slowdown with neither capacity constraints nor rising inflation. Au contraire, rather than capacity-utilization figures in the mid-80s percentage range where past cycles have topped out, this one rolled over in the mid-to-upper 70s. This low capacity utilization is a consequence of the tremendous surge in plant and equipment spending during the late 1990s technology boom and an acceleration of imports. Not surprisingly, few industries have been able to raise selling prices in an environment where all producers were struggling to fill up their excess capacity. Hence, inflation has been unusually benign.
The economic cool-down of 2001 was entirely a result of a cataclysmic drop in capital expenditures. While this is most unusual, it is completely consistent with the classic reality that the market eventually seeks out and corrects all excesses. From the early to late 1990s, producers' durables had grown to nearly twice their long-term share of GDP. One study shows that capital outlays by the communications sector alone hyped GDP by 1% a year in the late nineties and that its fall has subtracted from GDP growth at a 1% rate for the past year and a half.
Spending by individuals, which typically accounts for about two-thirds of GDP, barely skipped a beat in 2001. Rather, consumer debt going into 2002 was even higher than it was heading into the recession-and this despite a savings rate hovering near zero and an increase in unemployment, which usually causes consumers to cut back on big-ticket purchases like houses and cars. Now, if we are beginning to "come out of the recession," we will not have the wind of pent-up consumer demand at our backs. This is why in late February Alan Greenspan opined that, even if we are beginning an economic recovery, it is likely to be anemic by past standards. He does not expect a resurgence in inflation soon, and he does not have his finger on the interest-rate increase trigger.
I believe there is another important reason that the erstwhile leader of our central bank does not expect a robust recovery. As you may know, early in his career, Greenspan spent a lot of time with Ayn Rand and her devotees of Darwinian capitalism. And he has more than a passing familiarity with the Austrians' school of economics, including Joseph A. Schumpeter, who described for us the essential role of the process he named creative destruction. So Greenspan understands that capitalism has a dark side, a role to play that is not especially susceptible to management by the central bank. I believe he appreciates that every so often a free-market system needs to purge itself of unnecessary or obsolete assets in order to fulfill its function of allocating scarce resources to their highest and best use.
The up phase of the most recent business cycle was, as we all know, a free-wheeling, swashbuckling affair. Energized as it was by the rapid evolution of the Internet and visions of a cycle-free new era, the market allocated capital to exciting ideas, many of which we now realize should never have been funded. Corporations, their officers and directors motivated as never before by the market prices of their shares, leveraged their balance sheets in unprecedented fashion. Sometimes the purpose of the extra debt was to fund share repurchases; other times it was to acquire businesses, often at amazingly rich prices. Now, post Enron, we are beginning to realize that there were more than a few instances in which these same leaders were so caught up in the enterprise of beating Wall Street's estimates by a penny every quarter that they failed to exercise prudence in the establishment of accounting policies. Surely this was not intentional!
Suppose that Schumpeter were to reappear suddenly as an expert witness at one or another of the congressional hearings currently being organized. I imagine that he would make it clear to his interrogators that much of our current capital base has become unnecessary, inefficient and inappropriate-plants and offices that are obsolete, loans that were imprudently made and shares representing shattered dreams. These have to go. He would probably endorse full-disclosure accounting rules, but the culling process, he would assure the assembled wise persons, should be allowed to happen quite naturally. The market has been extraordinarily volatile, perhaps sensing that we have entered a period of creative destruction. Even now, it is separating the sheep from the goats. The process is inevitable, unstoppable and ultimately in the best interest of our nation.
Recession? What Recession?
Shareholders desperately want the downside of the business cycle to be over and the upside to begin because traditionally this has meant rising corporate earnings and rising investor optimism, which translates into higher P/E ratios. So Wall Street has been celebrating the recent improvement in short-term indicators such as manufacturing orders, retail sales, rising government spending, stabilizing book-to-bill ratios for semiconductors, companies beginning to meet (reduced) earnings expectations and the stimulus of low interest rates.
We are even hearing talk of a V-shaped recovery, a concept especially dear to investment bankers and momentum managers. Some stalwart observers, though, including Merrill Lynch's chief investment strategist, David Bowers, have reservations concerning the power of any emergent profits recovery. And for good reasons.
When I hear a forecast of a sharp recovery from the recession, a voice in my head responds, "What recession?" The sum of the last three quarters GDP growth is a positive integer. Only 3Q01 produced a minus sign, and just barely! The industrial-equipment sector was devastated, to be sure, but this weakness was more than offset by consumers' diligent trips to malls and car dealers. And of course, in 4Q01 federal outlays really kicked into gear. But even though we haven't suffered any kind of top-line recession to speak of, the bottom did fall out of corporate profits, with S&P 500 EPS down maybe 30%; this is why stock prices fell and why it feels like we had a recession.
The important question raised by all this data is, "How do sales recover when they never fell?" The even more significant follow-up question is, "If there is no sales recovery in prospect, what will drive profits north?" If that were not a difficult enough challenge for the optimists among us, the challenge is made even greater by increasing scrutiny of accounting policies. I have yet to hear anyone suggest that adjustments to the way corporations calculate and report profits are going to enhance earnings per share. Far more likely, accounting policy will exert an as-yet-undetermined degree of downward pressure.
We have taken on some pretty complex issues for such a short column, but we cannot sign off without touching on the pivotal issue of valuation.
As every student of market history knows, the average P/E ratio for large-cap stocks over 75 years has been roughly 15. The S&P 500 recently sold at 28 times depressed earnings and about 20 times the past peak in profits. Until 2000, the market's historically high price-earnings multiple was usually justified in terms of the low discount rate applied to future earnings and by expectations that profits would grow faster in the new era than they had historically. The low discount rate may stay with us, courtesy of global competitive forces, excess productive capacity and sluggish growth of end demand. But analysts who expect 15% earnings growth may find that the burden of proof has fallen upon their shoulders. If reported earnings don't perk up considerably in the next several quarters, the overall valuation of prospective profits could turn noticeably less sanguine.
So far, the "recession of 2001" seems to have been very mild; in that regard, some might say it was beautiful. On the other hand, if the consumer-spending shoe has yet to drop, we may have to deal with a "double-dip" recession such as we experienced in the early 1980s. It doesn't seem the stock market is prepared for that.
If it turns out that we have entered the early stages of something like a structural recession, we might have to struggle through a cleansing period of adversity and ride the stock market to more sober valuation levels. But if that should be our lot, we ultimately will count ourselves fortunate. With excesses behind us, we'll wake one morning to a vigorous and innovative economy energized for the next boom cycle. And we'll say to ourselves, now that was a beautiful recession!
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.