The Wall Street Rally: Watch Your Wallets

Been Down So Long It Seems Like Up To Me, the precocious 1966 novel by the late Richard Farina, defined the late 1960s counterculture. The stock market rally that’s pushed the Dow Jones Industrial Average back above 9000 for the first time since early January could be given the same title, and it might well come to define the much-wished-for financial recovery.

What’s pushing the stock market upward? Mainly, unexpectedly positive second-quarter corporate profits. But those profits aren’t being powered by consumers who have suddenly found themselves with a lot more money in their pockets. The profits are coming from dramatic cost-cutting — including, most notably, payroll cuts. If a firm cuts its costs enough, it can show a profit even if its sales are still in the basement.

The problem here is twofold. First, such profits can’t be maintained. There’s a limit to how much can be cut without a business eventually disappearing — becoming, in effect, a balance sheet in space. Secondly, when businesses slash payrolls to show profits, consumers end up with even less money in their pockets to buy the things businesses produce. Even if they hold on to their jobs, they’re likely to fear that they won’t have the jobs for long, which causes them to retreat even further from the malls.

Most companies that have reported earnings so far have surpassed analyst’s estimates, but that only means that earnings have been less bad than analysts had feared. According to the chief investment officer at BNY Mellon Wealth Management, if the companies that haven’t yet reported earnings show the same pattern a the companies that have reported so far, overall corporate earnings will have dropped 25 percent over the past year. That may not be as much of a drop as analysts had expected, but it’s still awful. Operating income for companies in the S&P 500 that have reported so far has been almost 29 percent lower than last year, more than 80 percent lower than 2007, according to Standard and Poors. Ouch.

“Better-than-expected” is Wall Street’s euphemism these days for “we’re happier than we thought we’d be.” But Wall Street is in the business of cheer leading, even when there’s really nothing to cheer about. It wants investors to think positively, on the assumption that positive thinking can be a self-fulfilling prophesy: If investors begin putting more money into the market, then the market will automatically rise, leading more investors to put in more money — until, that is, the rally ends because nothing has fundamentally changed in the real economy.

Keep your eye on the real economy, where unemployment and underemployment keep rising. It’s not as much fun as cheering and investing right now, but it’s far safer.

Originally published at Robert Reich’s Blog and reproduced here with the author’s permission.

10 Responses to "The Wall Street Rally: Watch Your Wallets"

  1. Anonymous   July 24, 2009 at 11:25 am

    Wow, is the the RB Reich who has been quasi-socialistic when it comes to the labor market and worker-business relationships?Is this something of a “mea culpa” from Mr. Reich? I don’t think I have ever heard him espouse the benefits of companies selling to consumers and companies making profits.Congrats Mr. Reich, you’re on the right track!

    • Anonymous   July 24, 2009 at 12:16 pm

      Superficial sarcasm. Reich knows we’ve been buying off the population with a ton of cheap debt rather than real wages, a policy that’s done more damage to capitalism in the last ten years than any communist might hope for. The guy who took out a home equity loan to buy a boat (actually heard him interviewed on NPR in 2006) probably now has neither house nor boat, and won’t be buying one anytime soon. Ask the guys who supply lumber, shingles, doorknobs, wiring, appliances, electronics, fiberglas and outboards whether they now would have preferred Mr. Boater to be able to finance it out of earnings. Funny how this didn’t happen in the 50s and 60s when workers saw real wage gains and we had much higher marginal tax rates (not to mention simpler financial products). What looks like Reich’s socialism is really his trying to save capitalism from its extreme version which, like anything else extreme, rather predictably blows itself up.

      • rohelio   July 24, 2009 at 10:30 pm

        shouldn’t forget the rosy 50-60’s were partially financed by the rape and pillage of our banana republic friends to the south. same same but different

        • AntiMarxist   July 31, 2009 at 1:29 am

          I don’t think so. The US economy dwarfed all of Latin America in the 1950s to 1960s. Any money ‘raped’ would have been insignificant to the total US economy.

      • Dmitry   July 31, 2009 at 10:24 am

        You are correct. Notice that the average real wages of U.S. workers were increasing during the 1950s and 1960s, but have not improved since 1971 — past 38 years! When calculating hourly wages in terms of 2007 dollars, wages were $16 in 1971 and about $16 in 2007. Prior to the 1970s the U.S. also ran trade surpluses not chronic trade deficits.* In addition, the executive compensation committees use to be prevented from robbing corporate capital and giving billions of dollars to individual executives because there use to be an effective combined fed-state 100% tax on any compensation above $2 million per year (later increased to $4). The tax was never paid, but it did serve to keep most of the profits inside companies and provided the funds for real growth. The model was rising wages for consumers and increasing capital funds for businesses. The 50s-60s policies were the formula for long term successful capitalism. Too bad the debtors system replaced it.* source U.S. Dept. of Commerce, and U.S. Census

        • Guest   July 31, 2009 at 1:11 pm

          Exactly, and nicely put. You might find interesting an editorial in today’s FT, which explains how wage compression (high for labor, low for management) in Sweden causes unprofitable companies to be killed off quickly, thereby directing capital to enterprises with better prospects. It probably also explains why in the ranking of countries for innovation (new enterprises, use of vc capital, etc.) Sweden ranked #1 and the U.S. is considerably farther down the list. Can you imagine GM and Chrysler being allowed to remain alive in a Swedish economy?

  2. devils advocate   July 24, 2009 at 5:37 pm

    Prof Reich:if the news is horrible, then how can the market go up?why not mention the govt via “stock liquidity” program(s)and other programs – such as smoke signals to the financials to nudge the stocks up…by the way, a rising stock market can create a wealth effect in a important percentage of big spenders and be good for pension funds and for the economy

  3. Hans Konstapel   July 25, 2009 at 3:08 am

    The pattern is highly predictable. Analysts predict an outcome. The company is “Better Than” the prediction. This means “Something is Improving” and BOEM, the stock market Moves Up. Looks like Manipulation.

  4. Bob Ritter   July 31, 2009 at 3:52 am

    Reich is right. It’s all self correcting, and he knows it. There are always going to be winners & losers in life. I bet he wishes he invested when things looked their worst! It seems ironic to suggest that a market which is down from 14K to 9K is overly optimistic. Still, the fair point that I do take away is the one we hear a lot today … “less bad” or not as bad as we expected is a far cry from things are a lot better. My chief concern is whether the underlying problems are not in fact worse.

  5. Tom Shillock   August 2, 2009 at 5:50 pm

    According to Leon Levy, a founder of Oppenheimer and Co. in the 1950s, analysts’ numbers (“expectations”) are arrived at in consultation with management. This enables the analysts the safety of flocking (herding, schooling) and to be more or less correct in order to preserve their well-cultivated illusion of prescience. It also enables management to beat the numbers thereby allowing them to collect their well-earned bonuses at shareholder expense and also to encourage investors who are unaware of this symbiotic subterfuge to buy more stock.