TCS Daily

Stock Market Blues

By Kevin Hassett - February 25, 2002 12:00 AM

The data have continued to buttress the view that there is a new economy out there, but the stock market has not celebrated. What's going on?

First, to the new economy story. Amazingly, productivity jumped at an annual rate of about 3.5 percentage points in the fourth quarter. At the same time, the labor market has shown clear signs of turning around, with initial claims for unemployment insurance trending farther and farther away from recessionary levels. Add that to a surprisingly positive number for fourth quarter GDP growth, and it is quite likely that the recession has already ended. If it has, then we have experienced something extraordinary and almost unprecedented. Productivity, which normally tanks in a recession because firms hold on to workers when demand falls, has increased substantially over an entire recession. How remarkable is that? In the last seven recessions, productivity tanked. Not this time.

This pattern is best explained by an improvement in firms' ability to retool on the fly and adjust their production practices to changing conditions. When demand began to fall, firms tinkered with their methods, and cut costs even faster. As a result, efficiency actually increased in the face of falling demand.

But along with productivity increase comes a profound puzzle. While firms have deftly avoided carrying ridiculously high overhead costs and have improved the efficiency of each worker, they have, nonetheless, lost tons of money. Indeed, profits have dropped even more in this recession than they do in a typical recession.

The numbers are striking. Up until this year, the worst profit performance during a recession in post-war history occurred during the recession of 1957, when profits dropped at an average annual rate of about 17 percent. During this recession, the average profit decline will be (assuming that the end of the recession is pegged at the end of last year) about 23 percent. All that, and output hardly went down at all. So how come profits are so bad? And does the high productivity indicate that a profit turnaround is right around the corner?

One story that is commonly heard is that the profit decline is a response to the over-investment spawned by the NASDAQ "bubble." Communications firms, the story goes, lost billions and billions laying down fiber optic networks that remain dark. Other investments that were stimulated by the stock market boom similarly went awry. This argument is certainly plausible. If firms purchased huge quantities of capital equipment, but did so in error, then output per worker will go up (since each worker has more machines to work with) but profits will not.

There is a big problem with this story, however. Profits in the communications industry are only a tiny fraction of total profits. And anyway, they have held up nicely, higher now than they were at the start of 2000.

The next story often heard is that the computer firms were expecting to increase sales sharply as broadband spread throughout the land, but that the absence of sufficient broadband deployment pushed demand for computers down sharply, killing profits in the high-tech sector. Profits in the industry have certainly been awful, dropping from a profit of $5.3 billion in the first quarter of 2000 to a loss of about $5 billion earlier last year. But again, total profits of domestic industries in the U.S. declined over the past six quarters by $115 billion. The computer story explains only a tiny fraction of the decline.

What sector accounted for the lion's share of the decline? Manufacturing, the durable goods industry, in particular. Primary metal, fabricated metal, industrial machinery, and motor vehicle manufacturers were all crushed. None of these industries was a glory story during the stock market boom. It is also difficult pegging the decline to plummeting demand. Automakers, for example, have seen their sales hold up well, and consumer durable purchases have been surprisingly strong. Interest rates have even been low, which usually boosts profits.

So what happened?

We will investigate this question extensively in the next few Greenbooks, but before we do, some speculation is in order, and the culprit may be the same suspect causing this productivity surge: the new economy. Here's why. By integrating the world's information, the new global network has significantly undermined the pricing power of manufacturers everywhere. Firms used to rely on corporate representatives to keep them informed about new product developments, giving their business to firms across the street. Today, they search for the best product and lowest price on the web, and buy from the local producer only when the price is right. Even though sales remain high, low prices put tremendous pressure on profits, and this occurs everywhere that local producers face foreign competition. In other words, everywhere.

If the new economy story is true, then the negative surprise in profits should not be focused in industries that had the biggest stock market increases, or the largest runups in investment. In that case, there may be a troubling footnote (for investors, at least) to the new economy story. Profitability may be significantly undermined even though productivity is enhanced. And if that's what we're dealt, then the stock market adjustment should be downward, permanent, and significant.

Alternatively, we could be looking at a classical recession. An oil shock and tight monetary policy may have hammered the industrial sector, just as they have in the past. In this case, energy intensive industries will be the ones showing the worst profit declines.

What do the investment data say? Stay tuned.

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