Looking for The Prevailing Wind The bulls and bears are both blowing plenty of hot air these days. The two sides do agree on one thing, though: The economy is so good, it hurts.
By Jim Griffin

(FORTUNE Magazine) – Bipolar disorder. Is that the problem? High as a weather balloon in one session, deep in the Dauphin's dungeon in the next. Or is it paranoia, perhaps? The stock market has certainly been distracted by a babel of nagging voices--suspicious that inflation or a slowdown in corporate profits or a tech burnout or all of the above are out to destroy it. A quick read of the Diagnostic and Statistical Manual of Mental Disorders (DSM-IV), unfortunately, fails to pinpoint the market's malady. But I still suspect that most of its problems are in its head.

My message to the stock market, as the immortal Cher once said: "Snap out of it."

First of all, the U.S. economy is so healthy that it gleams. (See also our story in First.) Private domestic demand--the spending of U.S. households and businesses--is flat-out booming. Some have labeled it a 4x4 economy, because gross domestic product has expanded by 4% or more in each of the past four years. But that's faint praise; the domestic private sector is rolling at a rate closer to 6%. The top-line GDP growth rate is "only" 4% because the economy has been hauling drag chutes in the forms of a record deficit on foreign trade and a swing from deficit spending to surplus in the federal budget. In any given quarter since the mid-1990s, had foreign trade and the government accounts been neutral, the U.S. economy would have registered a rate of expansion 1% to 2% higher than what we've seen.

Those drags are now in the process of diminishing. Global growth--and the shopping sprees that such expansion brings--is increasing, according to recent reports from Europe, Asia, Latin America, and even Japan. Indeed, the vigor of the rebound from the myriad financial crises of 1997 and 1998 has caught forecasters by surprise. The IMF, for example, expected global growth of 2.2% for 1999; it now reckons that it came in higher by half, at 3.3%. The recovery is rolling into mid-2000 with freight-train momentum. Latest evidence: the recently released IMF World Economic Outlook, which projects a worldwide growth rate of 4.2% this year and argues that the risks are skewed to the upside.

Global health, of course, is good for the U.S. economy--and the stock market too. Just consider one area: technology spending. Even if American corporations do cut back on their IT budgets, it is clear that the fast-growing economies of Europe, Asia, and Latin America are poised to play catch-up. As it is, U.S. exports have been jumping at a real rate of 10% over the past two years--a rate that should accelerate.

Sure, the Nasdaq 100 has dropped roughly 14% in the past two months (see chart), but this has hardly been the tech cataclysm many have made it out to be. Is the peak the only relevant reference point in the equity market? (Are battalions of boomers, supposedly investing for their golden years, only happy if they pay top tick? What's wrong with buying on sale?) Besides, the Nasdaq 100, you may recall, is still 54% above its level of seven months ago (and the S&P 500 index is a modest 14% higher).

Even if one were to concede--and one shouldn't--that the market is the prime mover of all economic phenomena, then a longer-term reference point (in fact, almost anything other than the Nasdaq highs in March) would seem to suggest cause for rejoicing, not the present gloomy soul-searching.

Not that rejoicing is so welcome these days, thanks to that mysterious "wealth effect." The Federal Reserve's best guess is that the deep-set investor optimism derived from the long bull market has contributed roughly 1% to the economy's growth rate in recent years. In other words, the wealth effect in recent years has been bigger than a breadbox but not quite enough to offset the drags from foreign trade and the U.S. budgetary policy. So now the upshot is: The economy is so good that it's bad. At least from an equity-market perspective.

This, in a nutshell, is the conundrum we face. To mute the boom, the Fed has to work against the tide. As cyclical vibrancy improves around the world, new orders for goods and services will strengthen. It's reasonable to expect that, industry by industry, global leaders will get their full share of the increased buying--and in the high-tech industries, those leaders are located disproportionately in the States. That's the good news.

However, for the Fed to be successful in slowing the U.S. economy, it will have to suppress domestic demand more forcefully than it will if global conditions remain subdued. Translation: more interest rate hikes. Such cyclical suppression in the past has fallen most heavily on credit-sensitive sectors such as housing construction and the furniture and appliances associated with it. That past is likely to be prologue as increasing Fed stringency raises the cost of credit, reduces its availability, and dissuades Americans from adding to their stocks of houses and cars.

You can bet those hikes will deliver another jolt to the stock market, but the damage is likely to be short-lived. That's because ultimately--the whimsical wealth effect notwithstanding--it is the economy that drives the markets, not the other way around.

That's not to say we'll see the likes of this bull again--at least in the foreseeable future. The unprecedented equity rise of the past several years is due, after all, not merely to the extraordinary climb of high-tech profits, but to more macro global factors as well. Weak economic conditions that arose out of Japan's rigid system and Europe's distraction with the euro spawned easy monetary policies everywhere. The result was a global abundance of liquid capital. That capital then flowed in large part to the United States, attracted by the virtues of America's supercharged stocks. These firehose flows of liquidity buttressed the prices of U.S. securities--most especially those new-economy wonders with scary valuations that have taken a dive these past few weeks.

In more stable cyclical systems--the kind it seems the global economy is becoming--the engine periodically becomes the caboose. For a time, that means, foreign equity markets may outperform U.S. stocks, and vice versa. The lead changes hands and then changes back again. That's not a crisis; that's a stable process. That's good.

The short-term result will be even stronger demand for U.S. exports--something the Fed knows will continue to make demands on American labor. Admittedly, it's a tough balancing act for Greenspan & Co. As the U.S. private sector moves from an engine powered by domestic demand to an outboard motor fueled by global buying, the Fed will help "flip the switch" by suppressing U.S. demand through its tightening of the money supply. That way, American production can ramp up to fulfill export orders without putting so much pressure on the labor force that it drives up wages--and further raises the specter of inflation. This switch is at the heart of the "soft landing" that we're all hoping for.

Swapping engine for caboose is a tricky thing, of course. And you can bet that the process is likely to add uncertainty to the current market anxiety. But don't be fooled by all the recent volatility and the bumpiness still to come. Those up-and-down days on the stock market are not a sign that the economy's in trouble. Just the opposite, in fact: The economy's so strong, the markets don't know what hit 'em.

JIM GRIFFIN, the former chief investment strategist at Aeltus Investment Management, is an economist and consultant in Hartford, Conn.