WASHINGTON, March 10 (UPI) -- Friday's unemployment numbers were truly dreadful -- 308,000 job losses -- yet the U.S. stock market, ignoring one of the most important monthly economic releases, was up on the day. According to accepted theory, this shouldn't happen -- new information should immediately be reflected in prices. What's really going on?
As with any economic data reflecting only one month, there are a number of quibbles surrounding the employment figure, of course. A huge snowstorm in the Northeast and bad weather throughout the month caused construction hiring to be weaker than normal at this time of year. About 150,000 military reservists were called up, removing them from the workforce, and causing that fraction of them that had been in paid employment to be recorded as job losses. January's figure had shown a substantial job gain, which was revised further upward, after a weak December. This new February figure could itself be revised, presumably downward (i.e. fewer job losses) when March data are announced in a month's time. And so on.
Nevertheless, in spite of the snowstorm and the reservists, the "consensus" expectation for the number had been a 40,000 increase. It is traditionally held that around 150,000 new jobs are required each month to absorb new entrants to the workforce. That figure may be down somewhat recently, as immigration, legal and illegal, appears to have slackened substantially, but even so, a loss of 308,000 jobs translates into a shortfall of around 350,000-400,000 jobs from what is required to absorb immigrants and other new workforce entrants.
That is a huge shortfall, and has big implications for consumer spending especially, which in 2001-02 was the principal engine of such economic growth as occurred. If, as suggested in this column in December, consumer spending indeed drops sharply in 2003, then both economic growth and corporate profits in the United States are due for a very poor year. Admittedly, a continued decline in the dollar against the euro, and a rapid improvement in the U.S. balance of payments, as a result both of reduced U.S. consumption and increased U.S. exports, will have the happy effect as far as U.S. companies are concerned of exporting the recession to Europe. However, that is hardly a matter for celebration in terms of the world economy as a whole, or in terms of the U.S. stock market's short- and medium-term outlook (it would probably lead to an exodus of foreign capital from the market, for one thing).
According to the Efficient Market Hypothesis, stock prices reflect all information publicly available relating to the value of common stocks, and prices adjust almost immediately to new information. Indeed, in the strong form of the EMH, stock prices reflect all privately available information as well, since corporate insiders are assumed to trade on the information they have, but which is not yet publicly available.
Friday's market action, therefore, was directly contrary to the predictions of the EMH. Since the employment information was far below the consensus forecast, it cannot have been "public" before the Bureau of Labor Statistics announcement at 8:30 a.m. Friday. Equally, it beggars belief to think either that BLS employees are engaged in a gigantic trading scam based on their own inside information, or that they are selling the information in advance to the major brokers.
Defenders of the EMH are therefore reduced to postulating that other information Friday must have counteracted the effect of the employment number, allowing the market to rise. Certainly the United Nations debate Friday, and the information revealed by U.N. weapons inspector Hans Blix was dramatic. However, it is hard to believe that it was sufficiently important, either in warding off a possible war or in making it more likely that the United States and its allies would emerge without significant damage, to move the market to that extent. Indeed, the debate, by demonstrating the very limited support enjoyed by the United States in the U.N. Security Council, would have been food for pessimists rather than optimists, one would think.
Of course, the unemployment announcement Friday is just one event among thousands that influence the markets each year. In principle, it would be perfectly possible for an individual such event's effect on the market to be swamped by a random fluctuation -- all market commentators, whether believers in the EMH or not, agree that there is a very substantial random element in the market's ebbs and flows, as well as an element depending on underlying factors, such as institutional investor cash flow patterns, which are by no means random but are unknown to ordinary market participants.
There is however an alternative model one can use to examine the market's reaction, based on more modern mathematical and behavioral theories than the EMH, which depends in a deep underlying fashion on Bayes' Theorem of probability, propounded by the Rev. Thomas Bayes in the early 18th century. If, instead of Bayesian probability rules, we examine market behavior using rules of fuzzy logic, developed in the 1960s, we see a very different pattern emerging.
Under a fuzzy logic analysis, market participants seek to make sense of their environment by constructing a paradigm, of where they think the political scene, the U.S. and world economy, and the stock market are going. Depending on circumstances in the market, the share of market participants believing in a particular paradigm, and the intensity of their belief, varies from time to time. As new information emerges, it is absorbed immediately if it fits well with the majority paradigm, strengthening belief in that paradigm and causing market activity that reflects the paradigm. Contrary information, weakening the paradigm, or strengthening an alternate paradigm not currently believed in by a majority of the market, is absorbed more slowly as market participants are reluctant to modify, let alone abandon, their current worldview.
To take an example from the distant past: In 1949, the U.S. economy was growing rapidly, with automobiles and housing particularly bright spots, no inflation, and gross domestic product well above all pre-war levels. Nevertheless, the stock market that year, as measured by the Dow Jones average, remained below its level of 1946, and half its level of 1929, while price-earnings ratios remained marooned around 7 times, less than half their long-run average. Good earnings and economic news was very largely ignored. The pessimistic paradigm of the 1930s had yet to lift; it began to do so only with the economic and market boost of the Korean War.
In the late 1990s, on the other hand, it was an almost universally held paradigm that the United States had entered a New Economy, in which productivity growth would be much higher than had traditionally been the case, new business models would continually appear and revolutionize one business after another, and the risks inherent in stock market investment had diminished to the point where much higher valuations were appropriate. Information that contradicted that paradigm, such as the explosion in shareholder wealth transferred to management by means of stock options, and the increased divergence between reported and taxable profits, was ignored by the market. Far from exhibiting rational expectations as theory would predict, the market, at its peak and for around four years prior to it, exhibited "irrational exuberance."
Events in early 2000 began to weaken the force with which the prevailing paradigm was held -- the "belief" in its salience, in fuzzy logic terminology. The continuing flow of new Internet businesses with ever more unlikely business models -- such as Pets.com, which aimed to grow rich through Internet sales of dog food -- began to exhaust even that market's appetite for new ideas. The passing of the millennium -- with its extra kicker to hardware and software spending to cope with the mythical "Y2K" bug -- caused the more messianic fires of 1999 to dampen (the Italian economy minister who congratulated himself in January 2000 on having spent very little money on Y2K preparation seems particularly sensible in retrospect). The beginnings of Internet bankruptcies, late in 2000 (Pets.com filed for Chapter 11 bankruptcy on Election Day) weakened the "belief" in the New Economy paradigm still further.
Nevertheless, it was not until well into 2001 that the prevailing paradigm began to change, and it was then only to reflect the idea that there had been a "bubble" in stocks directly related to the Internet, while the market as a whole, and the U.S. economy as a whole, remained sound.
This perpetuation of the "New Economy" paradigm was assisted by some remarkably lax statistical work by the Bureau of Labor Statistics. That body, and its sister, the Bureau of Economic Analysis, had changed the accounting of gross national product in the mid-1990s to capitalize computer software expenditure, just at the point when the amount of such software bought by corporations spiraled. Naturally, this change sharply boosted both GDP and productivity calculations, to the great joy of "New Economy" theorists. The annual recalculations undertaken by the BLS and BEA each July were on the other hand much less well covered by the media -- these concerned past years, and were thus "old news," after all. Needless to say, by July 2002 the revisions had removed almost all of the "Productivity Miracle," leaving the New Economy stock market with very little theoretical underpinning.
Following the Enron disclosures late in 2001, the market's predominant paradigm changed. Now the stock market had been in a bubble in the late 1990s, hyped by a few "bad apples" in corporate management. However, the market "crash" of 2000-2001 had corrected this, and the economic "recovery" of 2002, aided by continuing operation of the "productivity miracle" and the massive decline in interest rates engineered by the Fed from January 2001 on would ensure that current stock market valuations were amply justified. The consumer would, by holding up consumption and residential real estate, prop up the economy until business investment and spending resumed. There would not, absolutely NOT be a double dip recession.
That's about where the majority paradigm is today. Signs of economic weakness are explained as being caused by the approach to war in Iraq, or by a somewhat harsh East Coast winter in 2002-03. The economy remains fundamentally sound, and stock market valuations still much higher than the historical average are justified by the continuing rapid gains in productivity. The sharp fall in consumer confidence in February, and the large decrease in jobs revealed Friday, both of which contradicted this still relatively optimistic assessment (because of their implication for consumer spending) produced little immediate effect on stock market prices.
Monday's stock market action, after traders and analysts had had the weekend to think, was a different matter. The market was down sharply, which was attributed to most analysts to news about the upcoming U.N. vote, but in truth was unlikely to be caused by any such thing. In reality, the market's paradigm may be in the process of being adjusted. The majority "no double dip" paradigm is being held with less and less belief, and consequently is less and less able to influence the market trends. New voices are being heard, more bearish for the market and the economy, suggesting that a return to traditional valuation levels for the stock market is indeed inevitable.
Positive economic news over the next few weeks could reinforce the fading relatively optimistic paradigm and postpone the inevitable further market drop. But it wouldn't take much, now, to establish the dominance of a new, more pessimistic paradigm, at which point the stock market could drop quite rapidly to a much lower trading level.
After all that -- the replacement of irrational optimism by irrational gloom -- is what happened in 1929-32.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
