Al-Ahram Weekly On-line 19 - 25 October 2000 Issue No. 504
Published in Cairo by AL-AHRAM established in 1875

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The price of perfection

By Frederick Bowie

After several nervous months, US financial markets sold off last week on fears of a downturn in the economy and the prospect of war in the Middle East. After having spent most of the year ignoring the advance of oil prices, which first began to impact international transport costs more than six months ago, investors are now beginning to sit up and take notice. For individuals, there may still be time to salvage something of the last years' extraordinary gains. For the economy as a whole, however, it is probably too late.

Although it may be many months, or even years, before reality finally comes home to roost, a major shift in market psychology would seem to be already under way. On Thursday, as Israel launched undeclared war on the people of Palestine, and Brent crude broke through $35 for the first time since 1990, confidence in common stocks was seen to crumble. The Dow Jones fell nearly 380 points, its largest ever one-day loss, while the Nasdaq Composite, which represents America's premier technology companies, closed at its lowest level for the year, down almost 40 per cent from the record high set on 10 March.

America is now firmly embroiled in a bear market -- though the majority of politicians, bankers and households would seem unable to grasp this fact. Yet even after last week's rout, by all historical standards, Wall Street remains over-priced by anywhere between 40 and 70 per cent. Despite the dramatic declines of this summer, it is likely that the worst is still to come.

The latest market slump followed rising anxieties about the impact of fuel prices on inflation and consumer spending, consummated by a string of profit warnings from iconic US corporations -- large-cap growth stocks which set the tone for much of the extraordinary bull market of the 1990s. Intel, Dell, Lucent, Motorola, Dupont, even Home Depot, all lined up to inform shareholders that they would not be delivering on target -- in some cases, not even near it. A year ago, the markets would have brushed off the bad news as "company-specific." Not any longer. As Gary Shilling wrote in Forbes magazine: "These stocks weren't taken to the woodshed for a thrashing. They were shot on the spot." Suddenly, there are no more company-specific problems, only symptoms of a declining economy.

As a result, in the last six weeks, more than a trillion dollars of economic "worth" has vanished off the face of Wall Street. Some of it, one may suppose, may be flowing into the pockets of the elites of the oil-producing countries. Yet they, too, will have suffered, for they are also major holders of US equities. Where the rest of it has gone, or when it may come back again, nobody knows.

The individual decisions which led to this decline are doubtless every bit as irrational as the corresponding decisions which made 1999 possibly the best year ever for American investors, and certainly the best since 1928. Then the Nasdaq soared by an astonishing 90 per cent in a mere 12 months, as company after company trounced analysts' best forecasts, many seeing their earnings more than double year on year. Outperformance became the norm, and stock prices ran ahead even more rapidly than profits. As the US economy swept all before it, the concept of risk all but disappeared. In the sceptics' favourite phrase, stocks were "priced for perfection."

Throughout the long boom of the late 20th century, few people paused to question just where all this wealth was coming from, and those who did got little thanks for their pains. Yet the answer is not hard to find.

On one level, real corporate profits have been expanding as a percentage of GDP: returns to capital have outstripped returns to labour. This fact is evident to anyone visiting the States, despite the calculated hallucination of official unemployment statistics, and the general feeling of well-being emanating from the middle-class ghettos that surround our major cities like so many designer refugee camps. The result has been a rising disparity of income and expectation between the haves and the have-nots, creating a powder keg of social tension.

At the same time, the scale of corporate returns has been overstated by the process of economic globalisation, which has served to expand the US's share of global product beyond its real needs while externalising many of the country's very real costs. This sleight-of-hand has created a positive feedback loop with the strong dollar. Low dollar prices for foreign labour and commodities have in turn helped project apparent corporate profitability into a stratosphere well beyond any real improvements in productivity. They have also played a more general role by importing a synthetic deflation which has masked -- until recently -- the real inflationary pressures caused by the decline in savings rates and the extraordinary expansion of corporate and consumer debt. Excluding energy from the consumer price index also helps, of course.

Between 1994 and the middle of this year, $10 trillion dollars were thus added to the value of the US stock market, as the price placed on the head of American industry soared ahead of GDP growth. Much of that money came from "artificial" sources, such as derivative contracts. A lot of it also came from outside the US. Over the same period, America's current account deficit rose from one per cent of GDP to four per cent. More importantly, net external liabilities rose from two per cent of GDP to 16 per cent last year, and are set to hit an extraordinary 27 per cent this year, according to a recent study by HSBC.

For more than a decade, American companies have been radically overstating their sustainable earnings, and foreign capital has lent substance -- of a kind -- to this illusion. When the "outsiders" finally realise how few clothes this Emperor has on, I for one would not like to be standing in the doorway marked "Exit."

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