It’s W-Shaped!

BEST BRACE FOR A W-SHAPED RECESSION
By John Authers,  May 17, 2009

If you want to describe this recession, and this bear market, it seems to be easiest to give them a letter grade. At one point the debate was between a V (a sharp recovery after a sharp fall) and a U (a slower recovery with a longer time spent at the bottom). After the stock market crash last October, people started talking about the dreaded L (in which economic activity falls off the side of a cliff and then stays horizontal).

The rally of the past two months reflects the belief that the L has been decisively averted, and suggests investors are betting on a V rather than a U for the economy. This seems optimistic, particularly after much data last week reminded us that the global economy still looks weak.

But another letter is looming on the horizon: W.

In a W-shaped recession, or bear market, we hit bottom, rally, and then sink back once more before finally recovering. This arguably describes both the stock market and the economy of the US during the 1930s, where a renewed sell-off, and a renewed dose of human misery, ensued late in the decade when policymakers believed that the recovery was complete and tightened the economic screws prematurely. It is arguably the story of this decade: since 2000 stock markets have taken a vertiginous lurch down, rallied from 2003 to 2007, and then suffered an even greater lurch downwards.

But the case for a W for the markets from here, with a rally more like the 2003-07 recovery than a typical bear market rally, followed by yet another leap off the cliff, looks quite a strong one.

Jonathan Davis advanced the latest theories of Jeremy Grantham in this space last week. The founder of GMO now expects a VL shape, which is, in practice, a kind of W. In such a recovery, to quote Mr Grantham’s latest letter “the stimulus causes a fairly quick but superficial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and financial problems are corrected”.

Reliable valuation metrics have not yet reached the lows that they reached in previous bear markets. These would imply a low of about 400 for the S&P 500, which is currently hovering close to 900. But Mr Grantham suggests that important differences with previous cases, and the sheer amount of money that has been thrown at the problem, could justify the market bottoming at a higher level this time.

Thus he is bullish for now, even though he has been a long-term bear. This may essentially still be a bear market, but if this is a W-shaped rally then institutional investors want to be part of it.

That is the imperative for now, and we can leave until later the longer-term drags – dealing with the effects of reduced paper wealth, lower asset prices and a reduced financial sector – that mean, for Mr Grantham, that stocks will eventually move horizontally for a long time.

Russell Napier of CLSA suggested a rather purer W in an interview earlier this month on ft.com (at www.ft.com/shortview). His suggestion is that stocks can rally now because the fear of deflation has been vanquished. Any signs that inflation is creeping up can be dismissed as signs of normalisation and egg on the markets – until a savage bear market in bonds brings the edifice crashing down.

At this point Mr Napier, a historian of bear markets, believes stocks will retreat to the extreme valuation lows of previous bear markets (400 or so on the S&P) before recovering. But as it will take a while for inflation to recur, or for bond yields to rise to the kind of level that has damaged stock markets in the past, he suggests the current upward leg of the W could carry on for a matter of years.

To be clear, he is not using the discredited “Fed model” – valuing stocks by comparing their earnings yields to bond yields. Rather, the suggestion is that there could come a tipping point in the bond market when high interest rates have a depressive effect on the economy, and derail the stock market.

These are two different but persuasive arguments that we are in a W. Testing either hypothesis is difficult, as governments did not respond so aggressively to the deflationary scares of the past, and so we lack precedents. What history suggests, however, is that the worst bear markets do not end with a simple V – which is alarming as the last four months have produced a perfect V on the charts. Rather, bears tend to end with minor falls followed by incremental recoveries, built on rising volume.

This year has seen a big fall followed by a big rally on shrinking volume, exactly the opposite of this, so it might be best to brace for a W.