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The economy and our stocks are not separate things.


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Larry Kudlow

Stock-market investors have suffered through a big fat headache this year. And with so many investors today, the market decline has become a national migraine.

Economists, meanwhile, continue to talk about the so-called disconnect between the rising economy and the falling stock market. They say corporate corruption, accounting fraud, domestic security threats, and now a growing likelihood of military-induced regime change in Iraq are the root causes of the stock slump. Even the Fed has gotten into the act, blaming sluggish growth and falling stocks on “heightened geopolitical risks.”

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But you know what? The disconnect between the economy and stocks is not so large.

The speed of economic recovery is pathetically slow. In this stalled environment, businesses have no pricing power and very weak top-line revenue growth. Since they can’t raise prices, and sales revenues are scarce, they can’t make money. Without money, or profits, share prices keep falling day in and day out.

Christian G. Koch, the top technology analyst for the $50 billion investment firm Trusco Capital Management, writes in that “in a low-trajectory GDP growth environment, acceleration in tech top-line sales should be difficult to achieve.” This proposition is essentially inarguable. Perp-walking CEOs and special-force commandos heading to Iraq are not at the root of our pain. But a business slump is.

Mr. Koch points out that yearly revenue changes in all the high-tech sectors — including semiconductors, computer hardware, software, connectors, and networking equipment — are registering negative numbers. Revenue from the whole tech universe sank from 20% growth at the peak of the boom in March 2000 to a 20% decline-rate at the end of last year. Halfway through 2002 revenues were still falling at a 10% pace. So there you have it. There’s no way the technology-based Nasdaq is going to awake from the dead until those revenues start rocketing upward.

And if the revenue story isn’t bad enough, the pricing situation adds considerably more insult to the injury. Prices for information-processing equipment are deflating at a 4% rate. Software prices are dropping by nearly 1% annually. Computer prices are sinking at a 15% to 20% pace. Outside of technology, industrial equipment prices are falling slightly and industrial commodity prices are also dropping.

Falling prices plus declining revenues equals no profits and plunging stocks. This is called deflation.

So the question is: What happened to the economic recovery? Well, it’s not really a recovery at all. Statistically, gross domestic profit has been rising 3% to 4% since the end of last year’s recession. But this is only about half the normal recovery rate.

Retired New York Fed economist Leon Korobow writes in to say that today’s GDP increases are “the equivalent of zero to 1% growth ten years ago. Why? Because productivity growth has taken a quantum leap forward as a result of the investment boom of the ’90s and, consequently, the economy’s full potential is advancing well ahead of 3% to 4% growth.”

Think of it as a modern jetliner flying 65 miles per hour when it wasn’t built to fly below 135 miles per hour and can cruise at 500 miles per hour. If demand in the economy increases by only 3% or 4%, and profit margins remain slim, then business investment will no longer fly, technology will fall below the radar screen, and the productivity miracle will crash.

Like modern aircraft, modern economies cannot stay aloft if they are piloted at sub-optimal speeds. All the excess capacity in the technology sector will evaporate unless economic demand rises at a sufficiently rapid pace. Only economic growth can fill up that excess. And without sufficient growth, the supply-side breakthroughs of business investment and productivity will rot away. Gone with it will be any hopes of regaining full employment in the labor force — which includes hard-hit Wall Street.

Federal policymakers don’t seem to understand this. The Bush administration has given up on pushing investor tax cuts. Congress, rather than accelerating the income-tax cuts it passed a year ago, is focused on the mechanics of the midterm election battle. And rather than curbing deflation and raising demand by turning the cash spigots wide open, the Federal Reserve is busy pondering the Iraq factor.

Meanwhile, Wall Street runs a special election every day, and each stock-market decline is another overwhelming vote by investors who are fed up with poor economic leadership and a slow-flying economy. There’s really no need to wait until November. The vote tally is in. It’s a landslide message of no confidence.



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