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Here comes the bear

The fiscal stimulus plan and emergency rate cuts failed to revive stocks. Can anything turn the market around?

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By Alexandra Twin, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- With the Nasdaq briefly falling into bear market territory and the Dow and S&P getting closer to that status, it is clear that Wall Street doesn't believe fiscal stimulus and big rate cuts can prevent a recession.

And despite a late-day rally that lifted stocks Wednesday afternoon, some analysts think the market won't bounce back significantly in the foreseeable future.

Peter Morici, a professor at the University of Maryland School of Business, said a stimulus package and rate cuts won't be enough to fix the collapse of the credit markets.

Morici said that investors have a "lack of confidence" in bond ratings agencies and noted that Wall Street continues to worry about the possibility that some large bond insurers, such as MBIA (MBI) and Ambac Financial (ABK) could be "on the verge of default."

As a result, he said investors are worried the economy is going to continue to tank and that the structural problems in the financial sector are too big to be fixed by the government's current plan.

This gloom is weighing heavily on the market. Before Wednesday's rally, the Nasdaq (COMP) and the Russell 2000 (RUT.X) small-cap index were both down more than 20 percent from their cyclical highs, the textbook definition of a bear market. The Dow Jones industrial average and the broader S&P 500 (SPX) index are not there yet. But all the major gauges could soon be in bear territory. Here's why.

Wall Street skeptical of 'stimulus' plan. On Friday, President Bush outlined a plan that calls for about $150 billion in tax breaks. The plan, not yet approved by Congress, is meant to spark consumer spending, which fuels around two-thirds of gross domestic product (GDP) growth.

One proposal is the elimination of the ten percent tax bracket, which would mean rebates of about $800 for a single person and $1600 for married couples. (Full story).

The problem is that some market observers think tax breaks will only provide a temporary boost to consumers.

"Why would a one-time check make such a difference?" said George Feiger, CEO at Contango Capital Advisors, a wealth management firm.

For example, Feiger said consumers might use some of the rebate money to buy something, say a new hat. If enough people do that, the hat retailer can clear out some excess inventory, which is good.

But once the tax rebate is spent, there's no incentive for a consumer to buy another hat. And that means there's no reason for the retailer to restock. In other words, consumers are unlikely to spend their way out of an economic downturn.

Fed actions fail to reassure. On Tuesday, the Federal Reserve cut the federal funds rate - a key overnight lending rate that affects consumer loans - by three-quarters of a percentage point to 3.5 percent. The bank cut the discount rate, the cost at which banks can borrow from the Fed, by three-quarters of a point to 4 percent.

The emergency cut came over a week ahead of the scheduled meeting and was the first intermeeting cut since September 2001, in the midst of a recession and the panic following the 9/11 attacks. It was also the biggest fed funds rate cut since 1984. (Full story)

Yet, stocks tanked. Some worry that even though the Fed has cut rates three other times since September and is expected to keep lowering rates in the coming months, this may not do much in the short run.

"The Fed is trying to prop up the housing market, but the banks aren't in a position to extend credit, so it's not going to help consumers," said Haag Sherman, managing director at Salient Partners.

The emergency rate cut has also raised the specter of higher inflation at a time when oil and gold prices are not far from all-time highs and the dollar is relatively weak.

The 2001 plan had mixed results. Wall Street may also be skeptical because it remembers recent history.

The bursting of the tech bubble sent the economy into recession in March 2001, with the slowdown exacerbated by the aftermath of the 9/11 attacks. The recession is considered to have "ended" in November 2001, according to the National Bureau of Economic Research's official calculation.

The government tried to boost the economy by enacting a fiscal stimulus plan in 2001 that also relied on tax refunds. And the Fed aggressively cut interest rates that year. But this did little to bolster the economy or the stock market until late 2002.

Despite the government intervention and Fed's rate cuts, 2001 proved to be the second year of a three-year bear market. Stocks fell again in 2002 but finally bottomed in October of that year.

"The reality was it (the 2001 plan) was not that effective," said Hank Smith, Chief Investment Officer at Haverford Investments. "Consumers used the majority of the one-time payment to pay down debt and increase savings and consequently the economy only received a little boost."

What might help. Tax cuts for businesses could help, said Mark Travis, president and CEO Intrepid Capital Funds.

Tavis said that when the government lowered the capital gains and dividend taxes in 2003 it sparked a nice run in stocks. "If they made those cuts permanent or lowered them even more, the market would take off like a house on fire."

Reassurance from financial services companies - the sector most directly impacted by the subprime and credit crises - would help too.

"We need some banks to step up and say 'we've finally put everything behind us,' and the leadership should come from Merrill Lynch (MER, Fortune 500) and Citigroup (C, Fortune 500)," said Ram Kolluri, president at Global Investment Management.

Finally, it's just a matter of waiting it out a bit longer.

"Stock markets are reacting poorly due to problems specifically related to the financial sector," said Richard Behler, senior portfolio manager at Chartwell Investment Partners. "The market needs time to gauge the depth of these problems." To top of page

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