January 23, 2002


In an otherwise upbeat report on its performance, Intel, the semiconductor leader, announced that it will reduce capital spending by 25 percent in 2002.  Many of the energy trading companies, such as Calpine and Mirant also have announced sharp reductions in capital spending. 

In almost all metro areas, office rents are falling as vacancy rates are skyrocketing.  (In Atlanta , when the sublease space is added, vacancies are more than double levels of a year ago).  Hotel revenues per room are projected to be down more than 5 percent for 2002 while apartment vacancies have nearly doubled in several metro areas, including Atlanta .  Even if developers wanted to work on new office buildings, hotels or apartments, their bankers probably would say no. 

Capacity utilization continues to decline and is at 74.4 percent.  While this remains above the 71.1 percent low of the 1982 recession, capacity utilization is below levels that normally mean cancellation of capital goods orders. 

In short, another year of poor capital spending appears to be in store for the economy. 

About two years ago, capacity was growing about 5 percent per year.  Today it is expanding only 1.5 percent.  Before the slide in capacity is over, growth will be well below 1 percent. 

Only in 1932 has capacity actually declined.  But the current decline in capital accumulation probably is the fastest since those troubled Depression years. 

What are the implications of this sharp drop in growth of capacity?

First, the capacity of the economy to grow is slowing.  Although Greenspan continues to state that the long term health of this economy remains strong, the evidence supporting that statement is diminishing along with capital. 

Second, as much of the recent surge in productivity was related to smarter machines, the slower replacement of machines probably will be noticed in reduced productivity gains once the expansion is fully underway. 

Third, those Wall Street forecasts of 4 to 5 percent annualized growth rates in the latter part of 2002 are inconsistent with the capital spending programs that most companies are announcing.  Instead, growth may be much slower to take off than in previous recoveries. 

Fourth, inflation may return much quicker than anyone currently expects.  A large amount of unutilized resources puts downward pressure on prices.  However, rapid growth in capacity utilization leads to order delays and higher prices.  With capacity growing about 1 percent, not a lot a growth would be needed to sharply increase utilization.

Inflation should not be a problem in 2002.  But watch out for 2003. 

Fifth, those estimates of strong rebounds in operating profits also must be suspect.  With only minimal growth in the base of capital, how can profits jump so high?  Inflation, increased productivity, or reduced financing or labor costs could justify double digit growth rates in profits that many Wall Street firms are bandying about for 2002. 

Better productivity with less capital accumulation is suspect.  Higher inflation and lower financing costs are contradictory.  Labor costs might be cut further, but operating profits in the fourth quarter should be off 20 percent from previous year levels after substantial layoffs already have occurred.  In short, operating profits should grow only a few percentage points in 2002 following a 21 percent decline in 2001. 

Which leads to the sixth point: stock prices will not be able to rise significantly this year.  Wall Street analysts already are beginning to sense some problems in their forecasts, as companies are reluctant to raise earnings guidance for 2002.

No one believes that stock values will fall for a third consecutive year.  We need to go to the Depression for that.  However, small single digit profit growth can only justify double digit stock market returns if investors are willing to pay even more for earnings than they already are doing. 

This could happen, but is unlikely.  Higher prices per dollar of earnings usually occur either because falling interest rates raise the value of future earnings or earnings growth is expected to accelerate in the future. 

The Federal Reserve might lower rates one more time before they are done.  However, almost all analysts assume that rates will be trending upward before the end of this year. 

Earnings growth probably will accelerate in the future.  However, the capacity to sustain earnings growth is being undermined by the slow growth in capital accumulation.  Indeed, I would assume that the price an investor is willing to pay for earnings will be lower in the next several years than in the recent past. 

As I mentioned in my outlook column a few weeks ago, the Dow Jones average probably will struggle to reach 11,500 while the nasdaq probably will struggle to push past 2400.  From what I see about capital spending, I certainly would not raise those targets. 

mbar.jpg (9380 bytes)