Up From The Ashes

By Daniel Kadlec With Reporting by Bernard Baumohl/New York, Maggie Sieger/Chicago and Adam Zagorin/Washington

Just a day after the World Trade Center was flattened, tens of thousands of New Yorkers gamely hopped a train or a cab or walked to work as usual. What else were they going to do? Quit? Not likely. Similar pluck will mark the national economy. Sure, there will be economic tremors from the terrorist attacks. But the likely net effect--purely in economic terms--will be to hurry up and shorten a slowdown already in place and bring a quick end to the bear market that has gripped Wall Street since the Dow peaked in January 2000.

Much hinges on things we can't know. For example, will there be more such assaults? Will U.S. retaliation spur broad unrest in the Muslim world and perhaps threaten oil supplies? Until these questions are resolved, investors and consumers will sit on their wallets. Meanwhile, what we do know is plainly awful. Consumer confidence, already at an eight-year low before last Tuesday, will fall further. George Mees Jr., owner of GEM Floor Sanding Service in Villa Park, Ill., had a sale fall through just hours after the attacks. "I'm sure to get cancellations," he says. "Nobody's going to want to spend money."

Businesses will rein in their spending for a while too, virtually ensuring that the third quarter will become the first one with no economic growth in the past eight years--unless the second quarter gets there first. Domestic output in the second quarter grew at a rate of just 0.17% and could be revised to below zero.

Yet there lies the silver lining. In a matter of weeks, our first recession in a decade could be on the books. If it is and it lasts no longer than the last one (two quarters, the minimum period of contraction that qualifies for the R word), the downturn will be over almost as quickly as it became apparent. Recessions typically last nearly a year. The recent attacks, though, make everything different. Economic gatekeepers are in rare and sudden unison.

The $40 billion that Congress has pledged to help rebuild lower Manhattan and beef up airport security, among other things, will create jobs. And there will be even more spent on the military and possibly on bailouts for such hard-hit industries as airlines and insurers. For those who worry about potential deficit spending--get over it. Economic growth is the priority now. The Social Security "lockbox" was political propaganda anyway. It's all one big budget, and more of it might now be used to cut the tax most people pay on capital gains (remember when you had those?) to 15% from 20%.

The Federal Reserve, by flooding the U.S. banking system with cash, is giving lenders the confidence to extend credit without disruption. Expectations of further Fed cuts in short-term interest rates, along with the flight of money to safe investments late last week, helped push long-term interest rates to their lowest levels since the 1998 Asian financial crisis.

Trading wasn't always smooth after the bond market reopened Thursday. A communications breakdown with the Bank of New York, one of the main banks that process Treasury-bond trades, at one point delayed settlement of transactions worth at least $400 billion. By Friday, the bank insisted that "virtually all" problems had been solved, though a government official disputes that. At week's end the yield on the 10-year T-bond, which many mortgage rates are based on, stood at 4.55%, nearly a percentage point lower than it was four months ago.

If long rates stay down, millions of homeowners will get a chance to refinance mortgages and cut their monthly costs. Many will take out cash when they refinance and use it to pay off credit-card debt or start a home improvement. The jobless rate, while a point higher than it was last October, remains remarkably low--just below the 5% considered "full employment" only a few years ago. Inflation remains tame. And the dollar, weaker last week against the yen and the euro, will make U.S. exports more attractive.

So the seeds for a recovery, perhaps in early 2002, are being sown fast. Stock prices usually rise well in advance of any such turn. That's probably too much to hope for this week as the stock market reopens. Those industries clearly hurt by the attacks will get a tough ride--airlines, hotels, media, insurance and financial firms. General Electric and Ford on Friday warned of lower profits because of fallout from the terror attacks. Amid the early tumult, few investors will want to buy. That leaves sellers in charge of the market trend, at least for a little while.

Waiting in the wings, though, are hedge-fund managers and others who have been looking for a cathartic last push lower in the stock market. Their thinking now is that any disaster-related selling would amount to a final washing out of panic and set the table for another bull run. After all, the broad S&P 500 has already fallen 30% since March 2000. As corporations report earnings this quarter and next, many will start to look better compared with the weak earnings in the corresponding quarters last year. Oracle, for example, reported last Thursday that it had beaten analysts' estimates by a penny.

Even on Wall Street, there's a patriotic sense that a deep plunge would be a victory for the attackers. Within reason, traders will try to avoid that. Helping them will be new rules that make it easier for companies to buy back their own stock. Networking giant Cisco announced that it would buy back as much as $3 billion of its stock during the next two years.

There is much to suggest that any big downdraft would be met with eager buying. Foreign stock markets sank 5% to 10% on the day of the attacks in New York City and Washington, but bounced back or stabilized quickly. Mutual-fund companies report that few sell orders piled up while the markets were closed last week. And sectors including construction, defense, energy and security systems stand to do well in the months to come. Investing legend Warren Buffett, who was host at a conference for CEOs in Omaha, Neb., last Tuesday, told his guests the attacks "will not change what the market does one month, three months, six months or a year from now. The national psyche has been hurt, but for the financial markets, this is a nonevent."

The history of event-related sell-offs jibes with that bit of Buffett wisdom. Ned Davis Research looked at 28 crises dating back to the fall of France to the Nazis and found that in 25 of those cases, an initial market decline turned to solid gains within six months. The median initial decline in the Dow was 4.6%, followed by a rally of 12.1%. So maybe it's time to relearn an old lesson: Buy the dip. It hasn't worked lately. But now that it's no longer popular, it just might be smart.

--With reporting by Bernard Baumohl/New York, Maggie Sieger/Chicago and Adam Zagorin/Washington