Investors who try to use big stock market drops to predict economic problems could get themselves caught in one of the oldest bear traps around: that bear markets predict -- or even cause -- recessions.
"You know the old joke: The stock market has predicted nine of the last five recessions," said Mark Zandi, chief economist for Regional Financial Associates in West Chester, Pa. "It's not an infallible indicator."
Economists have been reluctant to christen the 18 percent fall the Dow Jones industrial average has seen since July 17 as the first real bear market the country has seen since the one that ran from December 1980 to July 1982.
And most do not believe the nation's economy is headed for a recession, though some of the big money-center banks and other economists say growth could slow to as low as 1 percent next year.
"We're looking for growth in the second half [of this year] of 2 to 2.5 percent and next year 1.5 [percent] to 2 percent," said Ira Silver, chief economist for J. C. Penney Co. Inc. in Plano, Texas. "That's a significant slowdown" but not a recession.
The questions on the minds of investors and economists alike right now are these: Are we in a bear market? And, if so, does that bear market mean the U.S. economy is headed for its first recession since 1990-1991?
Evaluating bear markets and recessions can be a tricky business.
Both demand the benefit of hindsight: You can't really call a bear market or a recession until you've been in one. And the definitions are a lot like tax codes of old -- if you look hard, you
can find lots of loopholes.
Take a bear market. The technical definition is a drop in stock prices of at least 20 percent.
What gauge to use?
But what index? Most look at the Dow Jones industrial average, the group of 30 stocks that the investment community uses as the barometer of the overall stock market's health.
But the Standard & Poor's 500 is a much broader index and is the index that's one of the components of the Composite Index of Leading Economic Indicators that many economists say is the best-available forecasting tool.
Both the Dow and S&P; 500 are down about 18 percent since peaking in July, short of the 20 percent threshold and too short in duration to be a bear market, some say.
"I'm not ready to call this a bear market," said Robert T. Sweet, chief economist for Allied Investment Advisors in Baltimore.
But others counter by saying that the stocks of small companies -- known as "small caps" -- have been in a bear market for months. The Russell 2000 index, one generally accepted measure of small stocks' health, is down 29 percent since peaking in late April.
With bear markets, there's also a question of duration and fear. Ibbotson Associates, the Chicago-based research house known for its stock-market insights, labels as a bear market the Oct. 19, 1987, Dow nose-dive of 508 points that over two months helped shave 29.5 percent off the S&P; 500. However, economists such as Sweet do not agree. They see the 1987 crash as a correction that was but a temporary breather in a bull-market run that began in August 1982.
The same is true of the Oct. 27, 1997, plunge of 554 points, which in percentage terms was a decline of only 7.2 percent. After that breather, the Dow would climb nearly 2,200 points -- or 23 percent -- to its mid-July peak.
"I think [the stock market] is a useful indicator, but it's not always right," said David Orr, chief capital markets economist for First Union Corp. in Charlotte, N.C. "You don't tend to have recessions without some disturbance in the stock market. But you do sometimes have stock-market disturbances without economic trouble."
Calling a recession is a bit easier than calling a bear market. Technically, a recession is defined by economists as a downturn in economic activity, represented by two consecutive quarters or more of decline in a country's gross domestic product (GDP).
According to government figures, using that strict definition, there have been eight recessions since World War II. Two were preceded by stock-market downturns that technically classified as bear markets: A 29.3 percent drop in the S&P; 500 from December 1968 to June 1970 that came before the 1969-1970 recession, and a 42.6 percent decline from January 1973 to September 1974 that preceded the 1974-1975 recession.
Pre-downturn corrections
Interestingly, there were several corrections exceeding 14 percent that began before economic downturns:
A 15 percent drop from March to December 1957 that came in front of the 1957-1958 recession.
A 15.9 percent fall from December 1980 to July 1982 that preceded and coincided with the 1981-1982 recession.
And a 14.7 percent decline from June 1990 to October 1990 that started before the relatively mild 1990-1991 recession.
The independent National Bureau of Economic Research, which most economists say has done the definitive study of economic downturns, defines a recession a bit more broadly than the government: a period of decline in total output, income, employment and trade, usually lasting from six months to a year.
By using the NBER figures, it's possible to take a longer view, matching its records against the Ibbotson Associates' bear-market records, which go back to 1926. Since that year, Ibbotson says, there have been 12 bear markets. During the same period, the NBER says there have been 13 recessions. The longest was the 43-month fall that began in August 1929 and lingered until May 1933.
The message: The Crash of 1929 did not precede the Great Depression, but began after the economy had already soured. Indeed, though the economy began its decline in August 1929, the Dow reached its peak of 381 on Sept. 3, 1929, a point it would not eclipse again until 1954 -- 25 years later. It would shed 89 percent of its value from its high-water mark to its July 1932 trough of 41.
For the same percentage decline to occur today, the Dow would have to plunge from its July 17 high of 9,337.97 all the way to 1,027.18 -- and not recover all its losses until 2023.
A big cause for the crash and the Depression that followed was a decision by the Fed to raise interest rates.
Instead of the stock market crash, the Great Depression was exacerbated by "one of the biggest tax increases ever in 1933," said Thomas DiLorenzo, professor of economics at the Sellinger School of Business at Loyola College.
The interest-rate boosts and tax increase "drained money out of the economy," heightening the economic pain, DiLorenzo said.
After the 43-month contraction ended, there would be two more bear markets before the United States entered World War II and the nation's economy recovered. But only one coincided with a recession: a yearlong bear-market drop of 50 percent that began in March 1937, ahead of a 13-month contraction that started in May 1937.
So, in light of the recent stock market turbulence, what's in store for the economy? After all, there is a bundle of bad news to ponder. The Dow remains down 18 percent from its high. Japan may well be in a depression of its own and seems to lack the political will to fix the deep-rooted problems it faces. Much of the rest of Southeast Asia remains deeply troubled, and concerns linger that China will exacerbate the situation by devaluing its currency. Russia is experiencing economic and political turmoil. There has been a dangerous, deflationary spiral in the prices of basic commodities such as oil. And the Federal Reserve remains vigilant about the return of inflation and may be loath to pump money into the economy by cutting interest rates.
One conclusion
That all adds up to one thing: recession, according to Allied Investment Advisors' Sweet.
"There is going to be a downturn between now and 2000," Sweet said, though noting that it will likely be mild.
Despite the problems, "one-half of the world economy -- Europe and the U.S. -- is still very sound," said Lynn Reaser, chief economist for the private clients group of NationsBank Corp. "The economy in the U.S. is able to withstand some external negatives. I still think that, even with what seems to me to be just a correction, there is still enough strength to support profit growth" by U.S. corporations. And it's profit growth that drives stock prices, she said.
Another worry is the so-called "wealth effect," which boils down to this: When the stock market is doing well, and individual
investors can gaze upon the big gains they have in their brokerage accounts and 401(k) retirement plans, they are more apt to spend. Conversely, when those individual investors see their holdings plunge in value, they may pull in their horns -- and put the brakes on their spending.
And on the economy. Consumer spending accounts for about two-thirds of the nation's $8 trillion economy -- or more than $5 trillion. But some economists such as First Union's Orr say that if there's any wealth-effect fallout at all, it's likely to be felt by the makers of luxury goods or casinos that bank on high rollers. If anything, companies that cater to the everyday consumer -- such as discount department stores like Wal-Mart Stores Inc. or Target Stores -- should keep doing OK.
And that means the economy should do OK, too.
Pub Date: 9/06/98