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U.S. Market Outlook – Uncertainty and the Market

By Scott B. MacDonald

The U.S. stock market remains in a stage of high volatility, reflecting a deep-seated degree of uncertainty over the future direction of global politics and the anemic nature of the U.S. economic recovery. While the prospects are good for a short-term equity rally based on the view that the war with Iraq will be short, there remain many dark clouds on the horizon. This threatens to bring dark days in the form of a plunging stock market, new terrorist attacks on U.S. soil, and the much-talked about double dip recession. With the Dow marching back and forth over the 8,000 mark, there is a good case to make that it could dip further, possibly below 7,000 before the end of the year.

Why all the gloom? At the end of the day, the fundamental issue is uncertainty. Markets hate uncertainty and we have plenty of it. Although we do not see a double dip recession and believe the U.S. economy is in a recovery mode, the pace and scope of that recovery is not strong nor is it convincing. As we have stated before, the U.S. economy is functioning like it did in the early 1990s. The actual recession, based on a contraction in GDP, is over, but there was a lag before sentiment changed for the better and recovery gained momentum. In 1991, the U.S. economy had a mild contraction, but expanded moderately in 1992 and 1993. The problem was that unemployment was high and for sectors of the economy, recessionary tendencies lagged.

We see the same pattern at work now, though corporate debt is higher. Although the U.S. technically did not have a recession (as there was not a back-to-back quarterly contraction in GDP), it has certainly felt like one and indeed the vast majority of Americans regard 2001 (and early 2002) as a recessionary period,. The problem is that the weak recovery is going to continue. The danger is that the U.S. economic expansion could glide lower, possibly stalling. The February uptick in U.S. unemployment from 5.7% in January to 5.8% should serve as a reminder that a very real downside scenario continues to sit on the horizon.

Our major worries are ongoing concerns about the Middle East and North Korea, the impact of higher oil prices (making itself felt at the gas pumps and in home heating bills), and the weakening consumer. Higher energy costs are certainly a negative for the already battered airline and auto companies. Added to that is the corporate sector’s reluctance to raise capital expenditures until there is greater clarity vis-à-vis the economy and geopolitical risks. Feeding on the uncertainty, banks and other financial institutions are nervously looking over their loan and credit card portfolios, though there has of yet been no major spike in non-performing assets. [In fact, many regional banks have reported non-performing assets of less than 1% of their loans in Q4 2002.]

Yet, for all the potential negatives in the market, not all is lost. Resolution of some of the geopolitical issues would go a long way in reducing uncertainty. With a few exceptions, corporate governance is improving. Sarbanes-Oxley is having a positive impact in making management clean up balance sheets. Although the problems at Ahold, the Dutch-owned supermarket giant were bad, it was the company that approached the Securities Exchange Commission to notify that agency that it had accounting problems. More significantly, the large debt overhang from the 1990s boom is being pared to more manageable levels and U.S. companies are much more cost-efficient than before. Finally, technical factors in the U.S. corporate bond market are strong – there is little new supply and a lot of money sitting on the sidelines wanting for the war scare to end and for companies to take advantage of very low interest rates to refinance. The few deals that came in February and early March were usually oversubscribed.

While we can be cautiously optimistic about the U.S. corporate bond market, we cannot say the same about the stock market. Equities have a long road ahead of them before we see another bull market. Some of these speed bumps include:

  1. Equity markets are no longer the source of cheap capital for industry as they were in the 1990s;
  2. Corporate problems will continue to have a quick and brutal echo in the stock market. Companies that get into trouble, be it with accounting or corporate governance issues, will be punished as investors will first flee the name and then shun it;
  3. Ongoing weakness in the U.S. and global economies undermines any extended rally. While the U.S. at least has a weak economy, with real GDP growth in excess of 2%, the same cannot be said of the world’s second largest economy, Japan, which is looking at 0.5-1.0% growth in 2003 and Germany, the world’s number three economy, which could slip back into recession.
  4. The tech sector continues to struggle, caught between the stark financial and economic realities and the need to push ahead for new innovations. Venture capital is hardly what it was in the 1990s and in most cases is being treated like spare silver bullets;
  5. While an Iraqi war may play out quickly, geopolitical issues are not going to be entirely eclipsed. North Korea remains an ongoing risk and al-Qaeda is hardly been eliminated; and
  6. It will take a long time for small investors to feel comfortable in investing in the stock market in a major fashion due to the billions of wealth lost in the market crash in 2001.
Consequently, we see the Dow as having another bear year in 2003, probably falling below 7,000 at some point, before recovering. The following year could see a recovery in stock prices, but that will depend on the ability of the economy to move at a faster pace than the 2.4-2.6% range and a decline in geopolitical uncertainties. Eventually the bulls will return, but at this juncture they remain out in the pasture, leaving the bears in charge of the street.

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Associate Editor: Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin,
Jonathan Lemco, Jean-Marc F. Blanchard, Barry Metzger, Russell Smith,
Ilissa A. Kabak, Andrew Novo, Jonathan Hopfner, C. H. Kwan, Dominic Scriven and Andrew Thorson

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