The Economic Outlook for 2003: A Promising Start (page 2 of 2)

After bottoming out in the 1990-91 recession, for instance, the index gained 27.8% in the following six months and 29.1% in the 12 months after the low point. This doesn't necessarily suggest the market is headed for stupendous gains in 2003, however. The S&P 500 has already gained about 20% since hitting a five-year low Oct. 9.

Many forecasters say the possibility of war with Iraq is holding the market back despite the improving economic outlook. Consumers, credited with keeping the economy together by continuing to spend during the past few years, are still doing so, and military spending by the government will help.

"What we don't have," says Marston, "is any turnaround in [business] investment, and we're waiting for it. I don't think that's going to occur during this war uncertainty." Many business leaders will hold off for fear of a spike in oil prices, he predicts. Adds Blume: "The war itself is not the risk. It's really the effect of oil on corporate earnings."

According to Marston, if there is not an oil crisis, the economy could enter "a traditional, full-fledged recovery" in the third quarter. He recalls that the S&P 500 fell about 15% in the two months after the Iraqi invasion of Kuwait in August 1990, but that it had regained all those losses, and continued higher, before President Bush declared a cease fire at the end of February 1991. "I see the [stock] market turning around sometime this year. I think it's going to be the result of some indication that the economy is turning around," Marston says. But "interest rates are going to rise. We know that." And rising rates are likely to hammer bond prices.

President Bush has added a new element to the mix with his $674 billion tax-cut proposal, centering on elimination of the income tax investors pay on dividends. Such a move would make dividend-paying stocks more profitable for investors, and the proposal has already helped boost stock prices, says Andrew Metrick, finance professor at Wharton. If Congress adopts the measure, stocks will further benefit; if it is defeated or scaled back to only a partial tax exemption, stocks may suffer, he suggests.

Most experts agree that the president's proposal is not so much a short-term stimulus as a long-term reform that could benefit the economy and financial markets in years to come. Still, some worry that such a major tax cut, if it is not matched by spending cuts, could make the federal budget deficit large enough to damage the economy.

"Adding a large, long-term deficit, which is what this risks doing, could have a very serious impact on long-term interest rates and seriously hurt investments," says finance professor Joao Gomes. "It does seem like a very dangerous path."

Investors also have not gotten over their worry about corporate misdeeds, says Metrick. "I think the big question on everybody's mind is, what other shoes are going to drop?"

The new accounting oversight board does not yet have a chairman and will take months to begin formulating rules to deal with the problems exposed by Enron and the other scandals. And it's too soon, Metrick says, to judge how well various corporate-governance reforms enacted last year will work. "Companies have become a lot more complicated over the past five years and corporate disclosure hasn't kept up," he points out. "Do we really know everything about these companies? If we go a year without any huge WorldCom-level scandal, I think that will be pretty positive for the stock market." But, he cautions, there is always a chance some new problem will undermine investor sentiment.

Most analysts have been aware, he notes, that plunging stock prices have undermined many pension plans. But they were still surprised when General Motors disclosed earlier this month that costs to shore up its under-funded pension plan would triple, reducing profits by 26%. Says Metrick: "I don't think that anyone knows the full extent of the problem."