What A Drag!

By S.C. GWYNNE

Smack in the American heartland, far from both Wall Street and Asia, the 15,500 workers of Harnischfeger Industries, based in St. Francis, Wis., got slammed from both directions. A proud world beater that builds mining equipment and huge machines that produce 70% of the world's printing paper, Harnischfeger has just seen its sales to Singapore and other troubled Pacific Rim countries drop from $600 million a year to nearly zero. Its stock, riding high at $44 a year ago, was beaten down to $16 in last week's market rout, gutting the 401(k) retirement plans of many of its employees. "What I have in Harnischfeger stock is down by two-thirds," says a glum Dave Trench, 57, a machinery stock attendant at a Harnischfeger subsidiary in Nashua, N.H. "When I look at retirement, I might start to sweat." At least he still has his job--for now. Harnischfeger announced in late August that it soon will begin dismissing 3,100 employees, or a fifth of its work force.

Look at Harnischfeger, and you can see the origins of the stock market's grinding 1,698-point decline, a loss of 8% from the July 17 peak of the Dow Jones industrial average at 9337.97. The company also offers a glimpse of what might come next, as American workers and investors like Dave Trench wonder whether the long boom is over. Should they pull their money out of stocks? Does the market slide foretell a recession? How is any of this bad news possible when the U.S. economy seems so strong, with the lowest unemployment, inflation and interest rates seen in a generation?

Like American business generally, Harnischfeger entered this turmoil strong and lean. Well-managed with a skilled and productive work force, it had prospered from the past decade's explosive growth in global freedom and commerce. But then came the currency crisis that began in Thailand in July 1997 and spread like a contagion through the rest of Asia--and last month to Russia and last week to Latin America, hammering down local currencies and slashing demand for U.S. exports. Cheaper Asian exports began grabbing more and more domestic business away from U.S. companies and sliced into their earnings. That trend finally drove down an overheated stock market, taking back, in the past seven weeks, almost a quarter of the $9 trillion that stocks have pumped into U.S. portfolios during the roaring '90s.

When the Dow plunged 512 points last Monday, investors at first regarded it as an irrational response to the financial and political turmoil in Russia--a vast country that still bristles with 7,000 strategic nuclear warheads but whose economy scarcely rivals that of the Netherlands and accounts for less than 1% of U.S. exports. Investors treated Monday's market action as another of those "dips" in which they had been taught to buy stocks on the cheap. Heck, it wasn't even as big as the one-day dip last Oct. 27, and the market had shrugged that one off within six weeks before powering to new highs and greater glory.

With that in mind, bargain hunters on Tuesday sent the Dow rebounding 288 points, in the second-largest single-day point gain in history. President Clinton, for whom rising stocks have covered a multitude of sins these past six years, tracked the Dow anxiously as he traveled to beleaguered Moscow. During a dinner with Russian President Boris Yeltsin, Clinton stopped economic adviser Gene Sperling in the receiving line to tell him, quietly but with palpable relief, that "the market's up" and flashed a thumbs-up sign.

But this time things were different. The Dow fell Wednesday. And the next day. And the next day, losing ground for the seventh trading day out of the previous eight and posting a 411-point, or 5%, setback for the week. Despite the release last week of fresh reports chronicling persistent low unemployment and rising orders for factory goods, anxiety spread from the stock market to the "real" economy of jobs and paychecks. The market drop served as a reminder--one about as subtle as a poke in the eye--that in today's global economy, not even a healthy U.S. can quarantine its factories and offices and markets from the illnesses of countries halfway around the world. It vividly showed Americans how the turmoil in Asia and Latin America is slashing the profits of U.S. corporations, which might be forced to respond with layoffs and cutbacks in spending.

Federal Reserve Chairman Alan Greenspan, speaking after the markets closed last Friday, revealed that Fed policymakers are worried that the threat to the U.S. economy from global financial turmoil rivals the danger of wage and price inflation. The Fed is now as likely to cut interest rates, he hinted, as to raise them. "It is just not credible that the U.S. can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress," Greenspan said in a speech at the University of California, Berkeley. Then he headed off to join Treasury Secretary Robert Rubin in a meeting where they urged Japan's new Finance Minister to deal with his country's insolvent banks and other financial troubles, which are dragging down not only the huge economy and financial markets of Japan but also those of other Asian countries--and now the U.S.

Only 21 months ago, with the Dow at 6500, Greenspan was warning against "irrational exuberance" in the stock market. Several other wise elders expressed hope that last week's correction will have the cleansing effect of strengthening the historic relationship between stock valuations and the earnings of the underlying companies--a notion that had fallen out of favor after years of "momentum investing," in which all that mattered was that someone would buy the hot stock that some greater fool would soon bid up to an even higher price. The price-earnings ratio for the S&P 500 has approached a record 30 this summer, twice its historical norm. Securities analysts, reassessing the impact of the turmoil in Asia and other foreign markets, last week began chopping down their estimates for growth of U.S. corporate profits, to as little as 3% for all of 1998, and zero growth for 1999, a sharp drop from last year's robust 12%.

In a bit of lucky timing, Fidelity Investments, the mutual-fund giant, last week rolled out a promotional and educational campaign starring Peter Lynch, its legendary fund manager. Lynch was troubled, he told TIME, that "in the first half of this year, the S&P 500 was up 15%, but [corporate] profits were down." He also expressed relief that the correction came now, rather than having the market drop to 7500 "after it's gone up to 14000."

There was remarkably little evidence of panic among individual investors last week. One measure of that is the amount of money that flows in and out of equity mutual funds. In August, a month that included several gut-wrenching weeks, there was a net outflow of $5.4 billion, or well under 1% of the total invested in equity funds. Though this was the first such exodus since the recession and stock slump of 1990, the number is still quite modest when compared with the 4% that fled equity funds after the October 1987 correction. Last week investors pulled a net $6.2 billion out of stock funds Monday and Tuesday, but on Wednesday a net $6.5 billion flowed right back as the market bounced, according to Trim Tabs Financial Services. "There has not been any retail panic as far as we can see," says Scott Chaisson, a branch manager for Fidelity in midtown Manhattan. "There seems to be an awareness that there are going to be ups and downs like this."

The real test, though, won't come until later, when new investors face the results of their first sustained market decline. An unprecedented 43% of adult Americans are now invested in stocks, up from only 21% in 1990. (That helps explain why we are hearing less Schadenfreude over the discomfort of Wall Street yuppies than in past corrections.) A striking 57% of all household assets today are allocated to equities. Small wonder: the market has doubled just since 1994. But these investors are about to get account statements showing declines of 20% to 30%. Even if they have been in the black over the past 12 months, not to mention the past few years, it will be a shock to be reminded, for the first time in years, that stocks can go down as well as up.

Investors large and small who had put money overseas in search of diversification, or simply higher returns, were sorely disappointed last week. Day after day, one giant U.S. bank after another came forward, like sheepish A.A. members fallen off the wagon, to confess they had succumbed to the lure of big returns from Russian investments on which--surprise!--the Yeltsin government has defaulted. Citicorp announced that its earnings for the third quarter will be cut by about $200 million in Russian losses. The price tag at Bankers Trust, about $260 million; at brokerage firm Salomon Smith Barney, $360 million in the past two months.

All told, U.S. financial institutions had losses mounting to $8 billion by week's end, and one of the fears that drugged the stock market was that U.S. companies might face even larger losses in Latin America, where they have much more exposure (about a third of U.S. exports) and where currencies came under fresh assault late last week. Brazil saw $11 billion in capital fleeing the country in the past five weeks--not because its economy is weak but because of each investor's fear that other investors might flee any economy slurred with the label "emerging." Money also fled the stocks of financial institutions with lots of business and investment in the emerging markets. Citicorp's stock dropped to about half of its recent high, losing $40 billion of market value.

Other companies that took major hits were transportation stocks whose business involves trade and travel: the parent companies of such airlines as American, United and Delta. Companies like Coca-Cola, Procter & Gamble and Gillette, which not long ago were praised for their successful penetration of global markets, last week were punished harshly through stock sell-offs. General Electric, the world's most valuable public corporation and one of the most admired, fell 22%, losing $68 billion of its market value.

The near panic over emerging markets was strongest among some of the hedge funds, the high-risk vehicles that often deliver high returns to wealthy investors. After famed investor George Soros lost $2 billion in Russia, John Meriwether's Long-Term Capital Management announced that it had lost $2.1 billion, or half its asset value, so far this year. "Russia and Asia became the trigger for the correction in the U.S. stock market," says David Wyss, chief economist at DRI/McGraw-Hill, a consulting firm. "Although there had already been a softening in earnings over the past few quarters, traders needed to be hit with a two-by-four to make them realize you just can't get double-digit increases in earnings every year."

Russia also became the trigger for another concern, at once political and economic: "We were suddenly threatened by an old fear--the Soviet Union and militarism," says John Silvia, chief economist at Scudder Kemper Investments. "If the world is not as peaceful as we expected, then a lot of money in the U.S. that went into consumer spending and capital investment may now have to go back to defense, and that's going to shock the budget here."

As the Dow ended its week at 7640.25, it was approaching one of the standard benchmarks for a bear market: a 20% drop from a previous peak. Many investors, though, have been in a quiet bear market for several months; that's because, during the last stages of the run-up in the Dow and the S&P 500, most of the increase was accounted for by such large companies as Coca-Cola and Microsoft; many smaller stocks were left behind. In the S&P 500, virtually all the gains in share prices in recent months were made by the 50 largest. At the same time, the Russell 2000 index of smaller stocks--traditionally favored by many individual investors--was off 29% from its April high. And as of Monday, the average stock on the New York Stock Exchange was off 38% this year. Even before last week, nearly half of U.S. domestic stock funds were losing money for the year.

Several economists see the current market as an untraditional bear market or, as Harvinder Kalirai, an economist at the consulting group I.D.E.A., sees it, what's happening on Wall Street is "a cyclical bear in a secular bull market. This is a cyclical fluctuation." The longer-term or secular trend in the market, though, "is still higher."

Many individual investors also hold that faith. Dennis Lese, 52, an executive with Amoco Corp. in Chicago, says that he is staying in the market but that the six-figure losses he suffered last week have caused him to postpone his planned early retirement. "I was thinking about retiring and living off stocks," he says. "But now I think I'll work a few more years."

Others seemed content to ride it out, in the knowledge that the gains of the past few years will cushion the impact of a down market now. "Anyone with brains knows the thing to do is to sit back and wait," says Stephanie Rubin, 52, an executive with a search firm in Chicago who has about $300,000 in stocks. "If it's down 25% on paper, it doesn't bother me because it's money tied up in an IRA account. I'm not going to touch this money till I'm 65."

Some people who were actively playing the market, however, were singing a different tune. "I was panicking," said Alan Herkowitz, 39, a New York systems analyst and a self-described "short-term trader" who invests "play money" in the market.

One of the biggest worries in a sustained market downturn is that it might depress consumer confidence and spending. Contrary to popular belief, though, big stock market drops alone rarely herald recessions. According to a study by Peter Temin, an economics professor at M.I.T., falling stock prices directly caused only one minor economic downturn in this century, in 1903.

But a slumping stock market can certainly add to the drag on a slowing economy, through the so-called wealth effect. In a rising market, economists estimate that for every dollar of increased wealth, consumers spend an additional 4[cents]. And they often stop spending that money when their stock gains erode. If $2 trillion has been lost from investors' pockets over the past seven weeks, then at 4[cents] on the dollar we could expect an $80 billion drop in annual consumer spending, or about 1% of the total U.S. economy. While that alone is not enough to stop the economy from growing, economists say, it could combine with the global currency crisis to tip the U.S. into recession later this year or in early 1999.

A persistent stock market decline can also hurt the economy by making companies more cautious about expansion and hiring. "If the stock price isn't doing well," says John Lonski, chief economist for Moody's Investors Service, "shareholders will put pressure on management to cut costs to improve returns." That usually means layoffs and plant closings, which "ripple through the economy" as laid-off people cut spending.

Pushing against these negative currents, fortunately, is the persistent, fundamental strength of the U.S. economy. The trend in wages and employment, which wield far more influence over consumer confidence and spending than stock prices, remains strong. As she placed a tortilla warmer in her shopping cart last week at a store in Nashville, Tenn., Sue Allison, 53, a public relations officer for the Tennessee supreme court, observed that "there are a million people out tonight spending $90 on nothing, just as I am. My husband and I won't touch [our retirement stocks] for at least 15 years, so I don't worry about short-term losses." In fact, aside from corporate profits and stock prices, most other leading indicators are pointing briskly upward. Orders from American factories rose 1.2% in July, the strongest performance since November. As investors around the globe sought a safe haven for their capital, long-term interest rates continued their slide to 5.3%, a silver lining for the U.S. in the cloud over emerging markets. Those low rates in turn have boosted the used-housing market, which recorded an all-time high of houses sold in July. Housing values, another important factor in Americans' calculation of their wealth, are rising smartly at about 5% a year. Unemployment stands at 4.5%, nearly a 28-year low, and only 1.8% for those with college degrees. Thanks to rising productivity, real wages have been rising for the first time in nearly three decades without spurring inflation. The U.S. growth rate, while down from its feverish 5.5% in the first quarter, is still expected to register 2%-plus for the rest of the year. The only skunk at this picnic is the Asian, Russian and Latin financial crisis, estimated to have knocked about 2.5 percentage points off second-quarter growth of 1.5%.

If recession comes, economists say, the cause will be the inability of countries such as Brazil, Indonesia, Malaysia, Mexico and Venezuela to buy as many U.S. exports with their devalued currencies--and the hit on U.S. wages and corporate earnings as cheap imports from those countries grab a greater share of the U.S. consumer's wallet.

At Nucor Corp., a $4 billion North Carolina steelmaker, the global tumult has hit home in both ways. Nucor's exports are down, falling globally from an annual rate two years ago of 700,000 tons to the present 30,000 tons, much of which is accounted for by Asian markets. But far more worrisome is the tough competition in the U.S. market from cheap steel made in Japan, Korea and Russia. Currency devaluations in those countries have made their products cheap for American buyers, says chairman Ken Iverson. "The U.S. is the only economy left that's doing well, so they're going to ship it all here." That makes America the consumer of last resort--a lifeline to many foreign economies, but at a heavy cost to many U.S. companies and workers. Again, such disruptions quickly get capitalized into stock prices: Nucor shares have fallen from $61 a year ago to $39 last week.

Another North Carolina company feeling the pain is Beacon Sweets, which makes, among other products, "gummi watches" (gelatin candy in the shape of a watch). Although most of its business is domestic, Beacon had begun to grow in China, Korea, Singapore, the Philippines and Japan. But over the past year, Beacon has seen its export business evaporate. Says Stephen Berkowitz, an executive vice president: "Our business in those countries has absolutely dried up as a result of currency devaluations."

Perhaps the greatest risk to both the U.S. and global economies is that today's hard times could bring a rising tide of global protectionism, including controls not only on trade but also on flows of capital. With the leadership in Russia and Japan virtually paralyzed, and President Clinton distracted by his personal problems, there is a danger that the trend toward freer markets could be reversed. This is already happening in places like Malaysia, which last week imposed foreign-exchange controls hurtful to multinational firms in the U.S. and elsewhere--not to mention to Malaysia itself, which will be hard pressed to attract investment. Nor is the U.S. immune. If unemployment begins to rise, blame will quickly attach to the rocketing U.S. trade deficit--one of the most immediate effects of the crisis in Asia--and will tempt members of Congress to impose new limits on imports. That, more than any other factor, could eventually lead to a significant recession in this country and others. "What we need is leadership," says Hugh Johnson, chief investment strategist at First Albany, a brokerage firm. "Without it, we have a vacuum, and the market always hates that."

For Clinton, much is at stake. The rising market and robust economy have long boosted his approval rating and made both his allies and his adversaries loath to cross him. A significant downturn in the economy, or a longer stock decline than expected, could make Americans feel much less patient with his foibles, and could embolden his enemies. Studies of polling show that a sour economy in 1973-74 contributed significantly to Americans' disgust with President Richard Nixon in the later stages of the Watergate scandal.

For American investors too, much is at stake. One of the worst things they could do is let rising volatility and uncertainty drive them out of stock investments. Returns on stocks have far outdistanced most other investments over time, producing an average annual return, after inflation, of 6.4% from 1927 through 1995, which includes the period when stocks struggled to regain the highs they reached before the 1929 crash and the Great Depression. Investors can also take heart that the stock market usually bounces back far more quickly than it did in the 1930s. In nine of the 11 months where the S&P 500 lost 4% or more since October 1987, returns were positive with-in two months of the drop. In all cases, including the 1987 crash, the market returned to positive returns within six months. As TIME's Dan Kadlec explains in the following story, most investors should stay with stocks, except when handling money they might need within the next three years.

For all its problems, Harnischfeger offers encouragement to other Americans at this uncertain time. Folks at the Wisconsin company have earned higher wages and have been able to educate their children better because of the profits they have reaped from the unprecedented spread of global commerce and free trade. But the price of that prosperity is a global economy so interlinked that the troubles of America's trading partners very quickly become its troubles too, even when America's domestic economy is showing remarkable resilience, as it is now. Harnischfeger's managers believe they are in for a rough ride for several quarters, but that the company's future, like that of the American economy, is bright over the longer term. Says Francis Corby Jr., the company's executive vice president for finance and administration: "We'll bounce back." They always have.

--Reported by Bernard Baumohl, William Dowell and Aixa M. Pascual/ New York, Julie Grace/Milwaukee, Alison Jones/ Durham and Adam Zagorin/Washington

With reporting by Bernard Baumohl, William Dowell and Aixa M. Pascual/New York, Julie Grace/Milwaukee, Alison Jones/Durham and Adam Zagorin/Washington