Tuesday's announcement that WorldCom Corp. understated its
expenses by $3.8 billion over the last two years, thereby overstating its
profits, is yet another blow to a stock market struggling to rise above its
post-9-11 lows. Not only must investors deal with almost daily revelations
about cooked books at major corporations, but they also have to figure out
whether the economic expansion is for real or a temporary respite before
relapsing into a double-dip recession.
Among the factors that investors are focusing on closely in
recent days is the falling dollar. Since the first of the year, the dollar
has fallen about 5 percent against major currencies. Investors fear that
this may be a harbinger of inflation, which could cause the Federal Reserve
to tighten monetary policy, and could put a damper on foreign capital
inflows. Foreign investors have been important in fueling the stock market
upward in recent years. As long as the dollar was rising, they got the
benefit of both higher stock prices and higher exchange rates.
All other things being equal, the stock market should be a lot
higher than it is now, given the underlying economic conditions. Those
conditions, insofar as we have data, are quite strong. Industrial
production, consumer spending and home sales are all doing very well. Only
capital investment is still lagging, but inventories remain low. This
suggests that business spending could rebound quickly.
It is worth remembering that the economy's problems and those of
the stock market resulted from the same factor: an excessively tight
monetary policy by the Federal Reserve. The Fed thought stock prices were
too high and that economic growth was too strong, both of which fuel
inflation in its economic model. This led the Fed to sharply raise interest
rates and tighten monetary policy.
The result was a deflation; that is, falling prices rather than
the rising prices that characterize inflation. Whereas inflation is too much
money chasing too few goods, deflation is the opposite, with too many goods
and too little money. Among deflation's effects is crashing corporate
profits. Companies make investment and other plans in expectation of getting
certain prices for their products. When deflation causes those prices to be
less than expected, profits necessarily take a hit. When profits fall, stock
The Fed was relatively quick to recognize its mistake, however,
and has been aggressively easing monetary policy for a year and a half.
Under normal circumstances, we should have seen signs of a rebound just
around the time Sept. 11 hit. And just about the time the effects of that
blow began to wear off, we had the Enron scandal. Since then, many major
corporations have had to restate their earnings; some spectacularly, as in
the case of WorldCom. But almost every big company has made adjustments to
its books in order to squeeze any questionable accounting out of them.
Thus the stock market has suffered a double blow over the last
nine months. But the important thing to remember, is that both Sept. 11 and
the Enron-WorldCom effect on earnings were one-time events. Once they are
over, they're over. They won't cause earnings to be permanently lower
forever, the way a tax increase would. Once the effects of these events is
absorbed into stock prices, their future course should be a function of the
economy's underlying strength.
Some have argued that the future may not be as bright as the
economy's current positive state would suggest. They argue that the Fed has
eased too much, setting the stage for inflation. The falling dollar, they
say, is a sign of that. But if prices and exchange rates are only returning
to normal after a period of deflation, then this is a good sign, not a bad
one. Indeed, some increase in prices and some fall in the dollar is the
inevitable consequence of Fed easing, and a necessary prerequisite for
sustained economic growth.
Others say that the Enron-WorldCom accounting scandals may bring
forth anti-business legislation and regulations. They fear that the Bush
administration will cave-in to them in hopes of currying favor with moderate
voters, as it caved-in to protectionist pressure in imposing steel tariffs.
But this would be a penny-wise/pound-foolish action, because anti-business
laws and regulations will push the market down further, costing the
administration far more votes than it might gain.
My view is that the fall of the dollar is not yet something to
worry about, and may in fact be the final sign that a deflationary trend is
finally over. If so, as prices regain lost ground, so will profits. Assuming
there are no more terrorist attacks or WorldCom-type announcements, I think
we should soon start to see higher profits at major corporations. Higher
stock prices will quickly follow.