August 7, 2001

Chief investment advisor of Goldman Sachs, Abby Cohen, believes that the economic storm is waning and that recovery is on the horizon. That is why she is looking for a 25 percent gain in Nasdaq and nearly a 15 percent jump in the Dow Jones index between now and the end of this year.

Unfortunately, the most recent economic reports do not suggest that conclusion.

Production declines to eliminate excess inventories may be at their bottom, but production is not. Consumers have held up well under the declines in jobs, but purchases of consumer durables propping up spending, not the more consistent nondurables and services. Consumer confidence is not turning up despite those rebate checks.

Moreover, those tax rebates may not have the same impact as the way they should be cause they are being sold poorly. Everyone talks about a one time rebate. In fact, it is an early return of tax benefits from permanently (at least until the tax sunset at the end of 2010) adding a new, lower tax bracket to the tax code.

Economists would expect a one time rebate, such as in the 1970s, would pay off debt and only marginally stimulate spending. A permanent reduction in tax burdens, however, is like a raise. Spending normally rebounds soon after the raise is made.

Now we have a raise that is viewed as a one time rebate. It should stimulate spending, but probably would do less than economic theory suggests because of how the tax rebate is being discussed.

Capital spending is slumping, which normally continues until spending grows faster than capacity. Most reasonable forecasts do not see that happening before the second half of 2002.

However, the most damaging report was the latest GDP estimates. If weak growth is removing imbalances, then a rebound is near. If growth is weak because strong areas, such as construction and consumption, are becoming weaker, then the weakness will be prolonged. That report was of the latter variety.

Consumer spending slowed to only little more than 2 spending, and spending in consumer durables was a substantial contributor to that. We have not yet deferred auto and luxury purchases (private planes and boats). Perhaps that auto sales slump in July is the beginning of that correction. If so, consumption growth will be lower the second half of the year than in the initial six months.

Indeed, of the 0.7 percent growth in GDP, 0.86 percentage points were contributed by purchases of state and local government. Most of those gains were for one time construction projects that almost certainly will not be repeated in the next six months.

To be sure, defense should rebound after Secretary Rumsfeld finally decides the new strategic military strategies. But the increased indebtedness needed to finance those activities will at least partially come at the expense of interest sensitive activity in the private sector.

When all these factors are combined, there is no evidence that the worst is over.

Furthermore, data revisions have significantly altered our understanding of economic conditions in the past three years. Economic growth was 0.3 percentage points slower than originally expected. (that will mean that productivity was overstated by similar amounts). The 3.5 percent annualized growth in the economy since the end of the last recession raises suspicions about the 3.2-3.3 percent annualized growth rates projected by the Bush administration for this decade. We got some growth by creating jobs that cannot not grow as easily in this decade.

Inventory accumulations and capital spending were less than originally reported. On the other hand, profits were much smaller. Those profits reported to analysts included appreciated investments that are not counted in national income accounting. We were rewarding companies for selling off appreciating assets, not earning more money from operations. Not surprisingly, reported profits are a disaster now that assets are not appreciating

Combined, the writeoff for impaired values at JDS Uniphase, Lucent and other communications companies as well as vendors such as Microsoft, Cisco, Oracle and others are in the hundreds of billions of dollars.

Indeed, my own stock market model must fall because of the 7 percent further decline in profits from previous estimates. An actual decline in economic activity remains possible for the summer and profit growth visibility could be delayed until next spring.

I want to believe, Abby, but these economic reports won't let me.


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