The Economy -- Stock Market to Limp Along

Slow earnings growth will be the source of weakness.

It has become increasingly clear that inflation and interest rates are not the only factors influencing stock prices. Earnings are just as important. In August the producer price index (PPI) fell 0.2% and the consumer price index (CPI) fell 0.1%. The actual declines were due to a drop in energy prices, which already have been reversed in September. But even excluding food and energy, the results were excellent. The core CPI rose its usual 0.2%, the finished goods core PPI rose only 0.1%, and the intermediate goods core, often considered the best leading indicator of inflation, actually fell 0.1%. So if higher energy prices are to be passed along to consumers later this year, it hasn't yet shown up in the Bureau of Labor Statistics indexes. Nonetheless, stocks continued to sell off on the news because of the realization that earnings growth will be sharply curtailed in the coming quarters. That invariably happens when the economy slows down, and can hardly be considered a surprise. Where are stock prices likely to head for the rest of this year? I think those who are expecting a fall rally similar to those of the last two years will be cruelly disappointed. In fact, for those who can remember all the way back to 1987, it used to be thought that October was a weak month for stocks. As usual, the optimists are spinning the recent softness in the market. We have heard this one before. Bad earnings are announced ahead of time, while good earnings are announced at the usual time. Thus, once we get through the current round of disappointments, the market should pick up a bit next month. In fact, stocks will rally from time to time. However, I think that on balance, for the rest of the year the negative surprises will outweigh the positive surprises, and the market will not move higher by yearend. In addition to the economic factors, I am sticking to my position that Gore will win the Presidency, and his victory will be viewed as bad news for stock prices. Now let's look ahead to 2001. I don't expect any significant changes in interest rates. The Fed could conceivably lower the funds rate to 6%, but in spite of the weak inflation figures in August, I am still concerned that over the next several months higher energy prices will boost the core rate of inflation slightly. It won't be enough to make a big difference, but it will keep the Fed from easing. As that viewpoint becomes wide-spread on Wall Street, bond yields also will remain in a narrow range. I am less certain what will happen to earnings. The dollar probably will remain strong as investors continue to avoid Europe and Asia. That means earnings from foreign sources will decline for two reasons: smaller profit margins in dollar terms, and translation of foreign earnings into smaller dollar figures. Multinational companies will thus find themselves under increasing profit pressures for much of next year. Energy prices eventually will retreat; that will depress profits slightly because the big decline in energy company profits will not be completely offset by the rise in other profits. That is because many energy-intensive sectors-utilities, transportation, etc. -- pass along energy price changes in either direction and hence are almost revenue neutral. The remaining question is how fast the high-tech sector will grow. Common sense would suggest there is still a great deal of water to be squeezed out of many of these companies, and all the bad news for Internet and dot.com companies has not yet been released. I also am wary of valuations of companies such as Cisco Systems Inc. at around 160 times earnings, even though it is a fine company and should not have any negative earnings surprises. Based on these factors, I think the S&P 500 will increase about 5% next year, with the Nasdaq composite up about 10%. However, the Nasdaq market has to be taken one day at a time. So in general, I expect stock market performance for 2001 to be weaker than the long-term average.

Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill.

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