Stock Shock

Alan Reynolds
Thu, 01 Mar 2007 00:00:00 -0800
Opinion

Sudden drops in stock prices typically provoke more panic among reporters than among investors. When Dow industrials fell by 22.6 percent on October 19, 1987, the press was quickly filled with alarmed stories about an imminent "hard landing" that soon proved quite foolish. Some of us who did not buy those stories bought stocks and bonds at bargain prices.

The market's drop of about 3 percent on Tuesday was comparatively trivial and brief, yet it too provoked some overwrought reactions from the press, and from perpetual bears. In the latter camp, economist Nouriel Roubini said: "Today we had a meltdown in many stock markets. ... What happened today is consistent with my outlook for a U.S. hard landing this year."

But what about what happened on all those other days when stocks were soaring? Last October, Roubini said there was a 70 percent chance of a "severe recession" by now, as noted in my column "Recession Fairy Tales." Yet he now relies on the stock market's performance on a single day to rationalize a recession forecast that keeps being postponed.
Updated: Wed Feb 28, 2007

Sudden drops in stock prices typically provoke more panic among reporters than among investors. When Dow industrials fell by 22.6 percent on October 19, 1987, the press was quickly filled with alarmed stories about an imminent "hard landing" that soon proved quite foolish. Some of us who did not buy those stories bought stocks and bonds at bargain prices.

The market's drop of about 3 percent on Tuesday was comparatively trivial and brief, yet it too provoked some overwrought reactions from the press, and from perpetual bears. In the latter camp, economist Nouriel Roubini said: "Today we had a meltdown in many stock markets. ... What happened today is consistent with my outlook for a U.S. hard landing this year."

But what about what happened on all those other days when stocks were soaring? Last October, Roubini said there was a 70 percent chance of a "severe recession" by now, as noted in my column "Recession Fairy Tales." Yet he now relies on the stock market's performance on a single day to rationalize a recession forecast that keeps being postponed.

What happened on that day was a rumor the Chinese government was planning to impose a new 20 percent capital gains tax on stocks. It is clear that this is what caused an 8.8 percent drop in Chinese stock prices on Tuesday, because there was a 4 percent rise the next day when that rumor was denied. Because Chinese entrepreneurs are major global investors, as well as major importers, that misperceived risk of a local tax shock affected many other markets in the world. To expect a "hard landing" in the United States from unconfirmed rumors about Chinese tax blunders, however, is quite a stretch.

U.S. reporters tried to pin the global market dip on homegrown issues. Some blamed a speech by Alan Greenspan, because he said, "While it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment." Recession is possible, in other words, but far from probable. Greenspan seemed strangely anxious that profit margins "have begun to stabilize," although they stabilized at a record high.

New York Times writer David Leonhardt was bolder. He wrote: "The U.S. manufacturing sector managed to slip into a recession with almost nobody seeming to notice. Well, until now. Wall Street was caught off guard when the Commerce Department reported yesterday morning that orders for durable goods — big items like home computers and factory machines — plunged almost 8 percent last month. ... In two of the last three months, the manufacturing sector has shrunk, according to surveys by the Institute for Supply Management (ISM). ... The main message of yesterday's worldwide stock sell-off — as well as the stealth manufacturing downturn — is that the economy is facing bigger risks than we imagined just a few weeks ago."

Leonhardt's legitimate concerns are too familiar and modest to imply that perceived risks suddenly spiked in a single day in the United States (as opposed to China). The drop in durable goods orders followed two strong monthly increases, and was only 3.1 percent aside from volatile orders for transportation equipment.

The ISM survey was old news, and having that index fluctuate between 49.3 and 51.5 for four months does not prove manufacturing is in recession. Industrial production rose 4.1 percent last year, helped by an 8.9 percent rise in real exports, and the manufacturing sector rose 0.8 percent in December, before dipping 0.7 percent in January.

Although growth of real GDP was only running at a 2.2 percent pace in the fourth quarter, that was because of running down excess inventories. The annualized growth of real final sales of domestic product was strong — up 3.6 percent. Real after-tax income also rose at a 4.4 percent rate during the final quarter and 5.4 percent for the year. These are not numbers that describe a recession.

Perpetual bears like Roubini rely on nebulous concepts such as "speculative excesses" and an undefined "credit crunch." During his academic career, Fed Chairman Ben Bernanke did considerable research on the use of financial indicators to predict economic downturns. One such indicator is an inverted yield curve, such as the yield on 10-year bonds being around 4.7 percent when the overnight fed funds rate is 5.25 percent. That's something the Fed can probably fix, if it chooses to, and the fact that growth of nominal GDP (inflation plus real growth) has been slower than 4 percent for the past two quarters is one reason why the market expects the fed funds rate to come down this year.

Another indicator is the "risk spread" between high-rated AAA corporate bonds, which were yielding 5.1 percent last week, and lesser-rated BBB bonds that paid 6.3 percent. Such risk spreads have not widened, as would be expected if financial trouble were brewing. Indeed, some have the hubris to claim risks spreads are too narrow.

Bernanke's favorite cyclical indicator used to be the paper-bill spread — the gap between the interest rate on 30-day commercial paper (5.23 percent last week) and three-month Treasury bills (5.03 percent). That spread is quite narrow and has not grown wider, so we can dismiss bearish talk about a looming credit crunch as empty rhetoric.

At The Wall Street Journal, Jonathan Clemens' column — "Yesterday's Market Lesson: Maybe You're Overstocked" — advised that "many investors have more in stocks than they really need." But the value of bonds also fell sharply on that same day. Following his advice to hold more bonds because of what happened to stocks the day before illustrates why market-timing is unwise — particularly when it involves a hasty reaction to market gyrations that often prove ephemeral.

A CNBC reporter remarked that February was the worst month for stocks since April 2005. Yet jumping out of stocks right after April 2005 would have meant foregoing a lot of gains. Nobody can be sure that is not also true today.

Be cautious when prices of stocks and bonds seem high (particularly if you are getting old) but never be too timid. When bearish forecasters and gloomy economic reporters are telling you to panic, that is often the very best time to stay calm.