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Listening to Wall Street
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November 16, 2001: 1:23 p.m. ET
U.S. stock and bond markets may be telling us something about the economy.
By Staff Writer Mark Gongloff
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NEW YORK (CNN/Money) - Is Wall Street trying to tell us something?
The stock market, a leading economic indicator, has been charging forward for almost two months, ignoring all manner of bad news, its eyes locked on the promise of an economic rebound next year.
"Every piece of bad news that comes out in the market ... is ignored," Barry Hyman, chief investment strategist at Ehrenkrantz King Nussbaum, told CNNfn's Money Gang program, "looking forward to 2002, in the second-half, when a recovery is going to be in effect."
Meanwhile, prices of U.S. Treasury bonds have plunged this week, and short-term interest rates have fallen far below long-term rates - steepening the "yield curve," the line connecting 3-month Treasury bond rates, or "yields," to 10-year bond rates.
"My favorite indicator - my deserted island variable, meaning this is what I'd ask for if I were on a deserted island - is the Treasury yield curve," said Merrill Lynch senior economist Gerald Cohen. "That's telling you we're expecting very strong growth over the next four quarters, albeit in the [second] half of next year."
Low short-term rates mean people and businesses are more likely to borrow and spend money in the short run, while high long-term rates indicate investors expect inflation to grow in the future as the economy picks up steam.
Economists haven't figured out yet when it will do that - or even when a possible recession began - but if the current stock market rally continues, it could be signaling an upturn, a recovery that could begin six months from now ... or immediately.
Most economists think the economy is in recession, commonly defined as two straight quarters of shrinking gross domestic product (GDP), triggered by the Sept. 11 terror attacks. Third-quarter GDP was negative, and most economists think the fourth quarter will be worse.
But you couldn't tell that by looking at the stock market.
Since Sept. 21 - at the end of the worst week for U.S. stock markets since the Great Depression, triggered by the Sept. 11 terror attacks - the Dow Jones industrial average and the S&P 500 have risen nearly 20 percent, while the Nasdaq composite index has risen more than 30 percent.
The bulk of those gains, of course, was a recovery to levels the markets held before Sept. 11. But the markets have done better than that, with the Dow up more than 2 percent, the Nasdaq up more than 10 percent and the S&P up more than 4 percent from their closing levels on Sept. 10.
Click here for CNNmoney.com's economic calendar
The stock rally has also shown surprising resilience, shaking off bad news in October about hundreds of thousands of job cuts, the threat of anthrax spreading in the mail, worries about more terror attacks, and what incorrectly seemed to be slow progress in the war in Afghanistan.
"Energy prices are dropping, and consumer spending is holding up despite rising unemployment," said Gary Thayer, chief economist at A.G. Edwards. "These are encouraging things the market is recognizing."
Many analysts think stocks usually rise several months before a recovery in the general economy. But the current economic downturn is different in a number of ways from normal downturns, and the stock market - and investors - could also react differently.
"This time around, my guess is that the lead may end up being shorter than the historic average," said Sung Won Sohn, chief economist at Wells Fargo & Co. "I wouldn't rule out the possibility of the stock market being an almost coincident indicator."
In other words, fourth-quarter GDP might not be nearly as bad as expected, a view supported by a rebound in retail sales in October and a reported recovery in the University of Michigan's consumer sentiment index. Consumers, who fuel two-thirds of the GDP, could also get a boost from the rapid successes for the U.S.-backed Northern Alliance in Afghanistan.
"Maybe the stock market bottomed on Sept. 21 - and maybe the economy did the same," Sohn said.
On the other hand, most economists surveyed by the National Association of Business Economics see a recession this year, and the National Bureau of Economic Research - which tracks monthly data to pinpoint the dates of recessions and expansions - hasn't yet seen enough data to pick the date of the recession, but says its most important indicator, employment, peaked in March and has fallen ever since.
And Friday's data from the Labor Department and the Federal Reserve showed prices shrinking as industrial production contracted for the 13th straight month, the longest run since the Great Depression.
Click here for more on the aftermath of Sept. 11
If the economy is in or near the last stages of a recession, history would indicate that this may be the right time to buy stocks, according to data compiled by Anthony Chan, chief economist at Banc One Investment Advisors. Chan compared the performance of the S&P 500 in the three stages of every recession since 1929 and found the index usually posted robust rallies in the final stage.
The S&P 500 registered average annualized declines of 18.4 percent during the first third of recessions, fell 3.1 percent during the next third, and then rose a whopping 41.4 percent in the final stages.
"History would suggest that getting [into equity markets] a bit early is often not too costly, since the lion's share of the negative performance is generated during the first third of a recession," Chan said in a research note.
Of course, stock markets have been wrong before, in part because stocks are driven not only by economic data but also by corporate earnings, which have been struggling much more and much longer than the general economy.
"The problem is that the stock market tends to predict downturns or upturns too early," said Wells Fargo's Sohn. "The common joke is that the stock market predicted 11 out of the last nine recessions."
For example, April saw a false spring for stocks, in which equity prices rose and technical indicators, such as the amount of margin debt, pointed to the beginning of a bull market. Instead, stocks continued to fall as the economy worsened.
"What's different this time is that there is a lot more stimulus now than any time in the past 50 or 60 years," Banc One's Chan said. "I've never seen a period with so much help from both the fiscal and monetary side."
In April, the Federal Reserve had only just begun its aggressive interest-rate-cutting campaign. Now, the cuts it made in January are beginning to impact the economy, since monetary policy usually has a standard lag time of nine to 12 months.
On top of the record-tying 10 interest-rate cuts by the Fed this year, the U.S. Congress is discussing a multibillion-dollar package of tax cuts and spending to stimulate the economy.
In fact, two reasons for the drop in long-term bond prices are trader fears about the future threat of inflation, government budget deficits and the increasing likelihood that the Fed is nearing the end of its rate-cutting campaign.
But other economists worry that Congress' slow pace in crafting a stimulus package could threaten a second-half recovery.
"The longer Congress delays helping the economy out, the longer the economy will remain weak," said A.G. Edwards' Thayer. 
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