The NASDAQ’s failure thus far to find a bottom is spreading a deepening sense of gloom even among bulls who thought sure they’d seen the whites of the sellers’ eyes after Tuesday’s hair-raising, 160-point, post-FOMC plunge. In a less pessimistic environment, today’s employment report showing healthy job growth against a backdrop of moderate wage gains might have at least blunted developing sentiment that a “hard-landing” scenario is now in the cards. But with the unemployment rate again posting a 30-year low of 3.9%, the fog of Fed-generated, Phillips Curve-inspired inflation fear has not yet lifted entirely. The market also now sees the Fed’s long-standing obsession with tight labor markets compounded by the energy-price wild card that entered the policy mix for the first time with Tuesday’s FOMC statement. For all that, though, there remains a store of fundamental strength in indicators of risk propensity which bode well for expected growth and suggests the NASDAQ’s vicious 21% dive since Sept. 1 should prove to be significantly overdone. 

After months of shop-worn postings decrying the dwindling “pool of available workers,“ the FOMC warned on Tuesday: “the increase in energy prices, though having limited effect on core measures of prices to date, poses a risk of raising inflation expectations.” Indeed it does, as we’ve noted here, the primary risk being that rising oil prices increase the opportunity for Fed error (“Greenspan’s Dilemma,” September 19, 2000).  Market participants, of course, were not ignorant of the oil-price environment before the Fed brought it to their attention. But for a nervous high-tech market still sporting eye-catching P/E multiples and already buffeted by a deluge of earnings warnings, the Fed’s acknowledgement of energy-price policy implications introduces an unwelcome overlay of additional risk.

On one level, it means that caution on oil could well hamstring the Fed from rolling back at least a portion of the 175 basis points in rate hikes effected since mid-1999 even in the face of significant economic deceleration. It also introduces the not-trivial possibility of an inflation uptick, either as a result of overt Fed error or a liquidity surplus arising from a slowdown-induced decline in money demand. That, in turn, would likely bring about another round of rate hikes, which may or may not suppress the inflation, but would be sure to further stymie growth and thus pose significant additional problems for growth-sensitive, higher-risk tech stocks. On top of that, since the capital gains tax is not indexed for inflation, any hint of a rising price level would carry with it a commensurate hike in the real, effective tax rate, reducing expected after-tax returns. That would have potentially devastating consequences for higher-risk equities whose market capitalizations are so closely tied to long-term capital gains expectations. 

Those are the elements of a worst case scenario, which likely would precipitate a recession if it came to pass. Any reasonable probability of such an event would also suggest an environment that was not conducive to extending the market’s capacity for absorbing new risk and financing the productivity-enhancing innovation that has been transforming the capital stock and spurring growth these past several years. Certainly, indications of a rising scarcity of risk capital would be cause for serious concern. Happily, that appears not to be the case. It’s true that a degree of risk aversion can be seen in the decline of the New-Economy benchmark NASDAQ index relative to the Old-Economy Dow. The NASDAQ/Dow ratio is down by more than 13% in the past month, and is some 36% below its March peak. A slightly longer-term perspective, however, suggests less cause for concern, as even now the New Economy/Old Economy ratio is up by about 19% over the past year, and nearly 70% in the past two years. Even more significant, though, has been the market’s strong appetite for new offerings. After a second quarter that nearly devastated the IPO market, the third quarter saw 142 new stocks enter the market with total proceeds of $24.8 billion, compared to 148 deals worth $21.6 billion in the same quarter last year, according to a quarterly review by ipo.com. In the midst of NASDAQ’s punishing September, 28 stocks worth $5.8 billion were launched, compared to 42 new entries raising $4.5 billion in the same month last year. Moreover, the ipo.com’s new-offering index rose by 15% for the month.

Industrial Production: High Tech versus New Economy

Investments in productivity-boosting technology that have accompanied rising expected returns to capital also show few signs of flagging. New orders for non-defense capital goods, excluding aircraft, are up at a year-on-year rate of 16%. Production of high-tech goods including computers, communication equipment and semiconductors is posting 12-month gains of better than 50%, even as non-high-tech manufacturing has shown little growth all year. Indeed, in the midst of the strongest sustained rates of economic expansion in a generation, production in the Old Economy smoke-stack industries has not posted year-on-year gains of more than 3% since mid-1998 (see chart).    

Up to a point, it can credibly be argued that for all the contemporaneous strength of these New Economy indicators, tech stocks are discounting for the inevitable slowing that lies ahead. In all likelihood, growth rates no better than 3-3.5% lie in store for the next few quarters. But NASDAQ appears to have gone well beyond discounting for those expectations and is now pricing for the worst-case outcome. That still seems unlikely. Provided that oil prices don’t return to the plus-$35 levels and stay there, chances are good that by the first quarter of next year the Fed will be moving to unwind a good chunk of the past year’s wholly unnecessary round of rate hikes. Anticipation of such a turn should go a long way toward restoring the market’s rally footing.