Aside from wondering when Chef Boyardee became an economist, you may also be curious about what these scenarios purportedly entail and how they may impact your investments.
The “V”
Most investors wou
ld like nothing more than a “V”-shaped recovery. With a “V,” the economy sees a sharp decline, hits a pronounced bottom, and quickly turns upward, canceling much or all of the losses that investors experienced on the way down. For the “V” to be plausible, the “less bad” news of second and third quarter will need to turn into actually good news.
Looking at the magnitude and velocity of the bounce following March’s market low, it appears as though Wall Street is pricing stocks with anticipation of a “V” recovery scenario. The best 5 month rally since 1938 benefited stocks across all asset classes and style categories, but favored lower quality, low-priced stocks of companies without earnings. Advisors Capital Management CIO Charles Lieberman says the possibility of a V-shaped recovery would increase substantially in the presence of a residential and manufacturing rebound, followed by the U.S. consumer returning to more normal spending levels. We believe this scenario is unlikely, as consumer spending remains soft, and the over-indebted consumer continues to feel the sting of depreciation of his greatest appreciable asset, his home.
The “L”
In his keynote address at the 2009 Morningstar Investment Conference, Bill Gross of PIMCO suggested a new landscape in which investors would have to get used to a permanently downgraded economy and much lower returns on all manner of risk-taking. Gross’ grim “new normal” suggests lower nominal GDP, lower profit growth, higher unemployment, reduced consumer-spending growth, and increased involvement of the government. In short, Gross was describing the consequences of the dreaded "L" scenario. The "L" is not economic recovery but rather the lack thereof. If the “L”-shape wins out, most investors don't. In this scenario the economy steadily declines, shareholders often lose value, and instead of an upward recovery, the economy simply plateaus at a lower level. Fortunately, we think the "L" is the least plausible of the economic scenarios. Given the unprecedented amount of stimulus spending in 2009, increasingly favorable economic indicators in the third quarter, and the sharpest market rally since 1938, the signs may not be giving the "all clear," but they're not really pointing in this direction.
The “W”
The “W” scenario, though ultimately resulting in a better outcome than the “L”, could end up making investors queasier, at least in the short run. Similar to the behavior in a “V” recovery, the economy falls, finds a bottom, and then trends upward. The difference, however, is that the uptick is only temporary, followed by another correction. Only after the economy finds a new bottom does it turn upward, as it would in the second half of a “V” scenario.
From an investor’s standpoint, the double dip may provide some a second round of buying opportunities, but what makes the “W” particularly insidious is that investors can easily mistake it for a sustained rally. Not wanting to miss out on the upside of what looks like a “V,” they have twice the opportunity to make costly and painful mistakes deploying their cash. All too often, investors’ inability to stomach loss, followed by their reluctance to pass up heady returns, leads them to sell at lows and buy into smoldering highs--it’s this behavior that gives the “W” its teeth.
For example, assume a scenario in which Wall Street is pricing stocks in anticipation of a “V” scenario, but in fact the economy is rising in the left-half of a “W”. An investor pushing cash back on the table after having pulled back during the decline could get burned again when the “W” crests and today’s rally turns into tomorrow’s swoon.
We think the "W" is a possibility, especially as economic conditions improve and the Fed looks to address the threat of inflation by removing excess liquidity from the market. U.S. Global Investors CEO Frank Holmes points to a Morgan Stanley study in which 12 of 18 equity market rebounds stalled within several months of interest rates being raised, suggesting that markets falter as governments begin to pull stimulus. Francois Sicart of Tocqueville Asset Management adds that fine-tuning the monetary policy amid a “semi-functional” financial system promises to be challenging, as any action on the part of the central banks may initially seem too little or too great, and the subsequent perception of these “stop-and-go” policies could result in tumultuous behavior within the financial markets.
The “U”
A “U”-shaped economic recovery is similar to the “V,” differing only in that the upturn is not as defined, as the economy waffles at its lows for a lengthier period before steadily climbing to higher ground. If you can't have a “V,” a “U” isn't a bad second choice.
We suspect that we find ourselves further from the “V” that the market is hoping for, and closer to a conservative “U” scenario that befits most consumer-led recessions. After all, at the root of the “Great Recession” is the over-levered, shell-shocked consumer that has experienced a significant decline in perceived wealth, a byproduct of fallen home prices, record unemployment, and credit markets as tight as those jeans at the bottom of your closet. The weak consumer balance sheet, coupled with an abnormally high personal saving rate, has put a sizeable dent in consumer spending and encouraged sluggishness in the trough of the “U". Lord Abbett's Senior Economist Milton Ezrati says that consumer-led recessions tend to take the shape of a "U" as consumers are unable to cut spending to the same degree as can the business sector.
Although consumers have recently cut back more sharply than anticipated, a confluence of factors and economic indicators suggests a slow “U”-shape recovery is under way.
In the month of August, the ‘cash for clunkers’ program inspired the sale of 15.5 million autos, a 16% improvement year-over-year, and 40% increase from the prior month. This tells us that, at the right price, the consumer is still in the game. Add to this the positive news in the housing market. Increases in housing starts, rising home values, and a decrease in foreclosures are all the kind of signals that the consumer is waiting for before dusting off the wallet and swiping the AmEx as if it were business as usual. Finally, it should be noted that the Fed and Mr. Obama are busily putting stimulus money to use, but as of September 30th, less than 25% of the pool will have been used, meaning the government can still flex its muscles if/when needed.
So Now What?
In a slower economic growth environment, we anticipate a reversal of fortune for stocks, with a flight to quality as investors temper their expectations with respect to the speed and trajectory of economic recovery. The lower quality stocks that have prospered in the recent rally will likely give way to those with stronger earnings and high returns on invested capital, as well as those that pay sustainable dividends. These quality companies have largely been left behind in the rally, but may soon have their time to shine.
For most investors, trying to time the market is a loser’s game, especially when many well-respected minds in the industry do not share a consensus view on the state of the economy. In times of greater uncertainty, owning quality companies with lesser volatility is a means of mitigating risk. Add to this a prudent dollar-cost-averaging strategy, and you can diversify your cost basis throughout any recovery scenario and ride out whichever letter comes our way.
