Wall Street's Ghostbusters

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But does all this mean that the economy and the stock market will roll merrily along to ever greater heights? On that, board opinion divides sharply.

Nobody foresees a continuation of the phenomenal 1998 rise in gross domestic product--a sizzling 6% annual rate in the fourth quarter, 3.9% for the year. But Cohen, true to her reputation as Wall Street's leading optimist, thinks the U.S. is in a "virtuous cycle" that will keep spinning, if a bit more slowly. The U.S., she notes, has created a stunning 15.5 million jobs since the end of 1993, even after subtracting job losses due to corporate downsizing. And two-thirds of these jobs pay more than the median wage for all U.S. jobs. By no coincidence, average U.S. real income has also risen in the past two years, after a long period during which wages rose less than prices. Result: consumers are willing to spend heavily, which creates still more jobs and higher incomes.

Corporate profits were the weak spot in last year's economy; they were slightly down, while just about everything else was up. But they rebounded strongly in early 1999, and Cohen expects that trend to continue. She explains that U.S.-based multinationals in 1998 "thought the global economy would perform better than it did" and got caught with the wrong plans. Having restructured over the past decade--not just to get rid of less profitable operations but also to concentrate resources on what they do best--they can now reap the benefits.

Putting it all together, Cohen expects operating profits of the 500 companies in the Standard & Poor's stock average to rise "a minimum of 7% to 8%" this year and next, while GDP goes up about 3%. Though less than last year, that would be well above anything that used to be considered "trend" (long-term average) growth. Battipaglia, even more bullish, forecasts twice as large a profit increase and GDP rises of 3.5% this year and "3% plus" in 2000.

Clough of Merrill Lynch is more dubious. He thinks "the consumer gets all the headlines, but business investment has been the economic engine." Though profits are rising, they are not going up fast enough to finance so rapid an expansion in capital spending, particularly in information technologies. So "corporations have to borrow in excess of $370 billion a year" to keep adding capacity, and that capacity is, in his opinion, more than consumer demand can absorb.

The investment cycle might have begun to slow last summer, but the Fed, fearing a global financial crisis, pumped money into the capital markets at an astonishing rate (its current tightening is a kind of confession that it went too far). But that, says Clough, created an inflation in financial assets and real estate that may prove unsustainable. "I worry that earnings may slow down next year. No recession; things aren't that out of kilter. The way capital cycles usually behave, though, if they lose momentum, things tend to slow for a long time. In that environment, interest rates would fall, and bond prices and interest-rate-sensitive stocks would rise."

Biggs of Morgan Stanley will not actually forecast a recession either, but he does say "there's a possibility" of one. If it comes, he says, it will be "because of something happening in the stock market." He believes stock prices are 30% to 40% overvalued, mostly because investors have bid up prices in expectation of a greater rise in profits than will occur. "These are still tough times for profits," he says. "Corporate managements have used every trick in the book to make profits look as good as possible, and I think you can do that only for a certain amount of time." While Biggs believes there are good investment opportunities overseas, he implies a sharp correction in U.S. stock prices or, at minimum, a long period of treading water.

Even the optimists concede that the market will have a hard time matching its striking performance of the past few years. Cohen in particular built a towering reputation in her specialized field by downplaying such traditional tools of analysis as dividend yield and price-earnings ratios, emphasizing other factors such as the durability of future earnings growth and return on equity. For years she insisted stocks were undervalued when most other analysts thought the opposite.

Now, she says, "the market is roughly at fair value. Stocks are priced about where we think they should be. So I think we have moved from an abnormal period of wonderful returns into a normal period of good returns." Amplifying the thought, Farrell sees the beginning of "a rifle-shot stock- picking environment" in which stock performance varies widely not just by industry group but also among companies in the same industry, based on their individual performances and prospects.

Who is right? The wide differences of opinion on matters other than the outlook for interest rates and inflation probably reflect the extent to which the length and strength of the expansion--if it lasts through next February, it will be the longest in U.S. history--have rewritten the rule book for forecasting. For at least two years, economists following conventional models have predicted a slowing of growth and modest rises in unemployment and inflation; the exact opposite has happened. So forecasters must search for new models, and it's anyone's guess who will find the most accurate one. But unless something happens that is much worse than any board member foresees, the outlook for the economy recalls the old gag about sex: when it's good, it's marvelous--and when it's only so-so, it's still pretty good.