One can’t watch or read any daily news without seeing a new perspective on the ‘shape of the recovery’, with economists, money managers and pundits strongly arguing their respective points. In this letter, we will outline the more popular theories. Get ready for some alphabet soup!
A ‘V-Shaped Recovery’ takes place when the economy rapidly contracts into recession, and is then followed by a sharp, strong recovery. A graph of an economic recovery in this fashion resembles the shape of a ‘V’. Most economic recoveries resemble this shape, as historically, the harder the fall, the stronger and swifter the recovery. This is especially true when the cause of the economic shock is external, as is the case here. If not for the coronavirus, most think we would still be in the middle of the longest bull market in history. The tech bubble recovery was a V-shaped recovery that was short lived, as it was quickly followed by 9/11. A V-shaped recovery means everyone quickly gets back to business and spending. The International Monetary Fund currently predicts a V-shaped recovery, as does every other pundit on TV.
A ‘U-Shaped Recovery’ is when things recover in a healthy fashion, and relatively quickly, but by no means is it ‘all systems go’. In other words, people get back to business, but in a more gradual fashion. Under this scenario, things are getting better all the time, and there are no major setbacks, but it takes months or even a year or more to get to full steam again. Our most recent recovery, after the 2008/2009 financial crisis, was a U-shaped recovery, albeit a far slower one than normal. By comparison, if we are really in a U-shaped recovery now, we are on pace to recover several years faster than we did after 2008/2009. Those predicting a U-shaped recovery include JP Morgan, ING, and CNBC’s Jim Cramer. A U-shaped recovery is also the favorite choice of 50 economists surveyed by Reuters.
A ‘W-Shaped Recovery’ takes place when the economy rapidly contracts, appears to sharply recover, only to collapse again before the real recovery. A graph of an economic recovery in this fashion resembles the shape of a ‘W’. The early 1980’s recession, one some readers may recall, is the most recent example of a W-shaped recovery. In 1980, the economy fell into recession, only to quickly recover. The recovery took place so quickly that high inflation accompanied it. The Fed dramatically raised interest rates to slow inflation, only to drive the economy back into recession. The economy ultimately recovered in 1983 and continued a period of incredible growth that went on for over 15 years. Many economists believe we are in the middle of a classic W-shaped recession. They hold that the V-shaped recovery we are currently experiencing is really the middle of a W-shaped recovery, which means we are in for another massive move downward before the real recovery begins. This group of prognosticators, which includes Moody’s Analytics, argues that the recent stock market run-up is really a head fake.
With an ‘L-Shaped Recovery’, the economy stays weak for many years until it finally recovers. An L-shaped recovery has never happened in the United States. For a modern-day example, we need to look to Japan, which plummeted into a severe recession in the late 1980s, taking nearly 20 years to recover, and never again reaching its rapid growth rates. In short, this would be really, really bad. Barclay’s says there is a “chance” of an L-shaped recovery. Of course, there is a chance for anything to happen.
Quickly running out of letters, we turn to a mathematical symbol, the square root. With a ‘Square Root Recovery’, the economy plummets, quickly recovers, then stays flat for a period of years. The idea of a ‘square root’ recovery is new, and there are no modern historical examples of it, but, hey, there’s a first for everything.
We could go on and on here. There’s talk of a ‘Nike swoosh’ recovery, which implies we have seen the bottom already and will embark on a slow upwards trajectory. And heck, you can make up any shape you want. The only rule is the line needs to keep moving to the right. If you can make a shape that follows the left to right rule, well, it can happen.
So, what is one to do with all this?
An investor who believes in a V-shaped recovery would likely do best entirely invested in stocks, as a recovery can only be sustained if corporate profits increase, thus driving up stock prices. Someone with very high conviction would load up on small cap stocks, with the knowledge that in 9 of the 10 most recent recessions, they have greatly outperformed on the upslope. An investor believing in a U-shaped recovery would also invest heavily in stocks and tilt to smaller stocks, knowing that the market moves ahead of the economy. An investor believing in a W-shaped recovery would rotate from bonds to stocks, then back to bonds, and finally again to stocks during each step of the recovery (good luck with that). An investor believing we are in the midst of an L-shaped or square root recovery would be best served in bonds, as the yield received would be one of the best investments available in an economy weak enough that companies aren’t profitable and real estate prices stay low due to lack of demand.
So, what are all these predictions essentially worth?
The greatest minds in economics and finance can’t reach any sort of agreement, and the reason for that is because no one really knows what the recovery will look like. There have been 31 recessions in the United States. This is hardly a sample on which to base anything. Likewise, we find it hard to take seriously that a ‘shape’ can be predicted at all. There are simply too many variables in play, and they have never intersected in the current fashion before. Also, keep in mind that there were plenty of factors impacting expected market returns before COVID-19 stole the show. Those factors are still in play, and anything can change the calculus overnight, from a terrorist event to a regional war, from the death of a world leader to any of the hundreds of variables that impact market returns like interest rates, tax rates, and supply and demand.
Albert Einstein said, “When the number of factors coming into play…is too large, scientific method in most cases fails. One need only think of the weather, in which case the prediction even for a few days ahead is impossible.”
The same can be said for the economy.
The bottom line is that investing based on guesses as to how the economy will move has a word to describe it: speculation. That’s because moving your investments around based on the unknown is a guessing game, and in the world of investing, that tends to end badly. A wise investor is focused on designing and implementing a portfolio that has the highest probability of meeting their short- and long-term needs, regardless of how the economy twists and turns in the short run. Many Americans lost a tremendous amount of money – some permanently – by moving to cash as the market plummeted, and getting back in far too late if they got back in at all. Such are the harsh realities of investing based on the day-to-day notions of prognosticators.
Our position remains the same as it was before the crisis: every investor should hold enough high quality bonds to provide for income needs for the short run (and by short run, we mean years, not months), and enough in stocks to meet long term needs.
One final note on recoveries: all major economists have their various predictions on the current situation, but all of them have the word ‘recovery’ in it.
We remain confident that the recovery, whatever shape it takes, is inevitable. And in the end, for properly positioned investors, that’s all that matters.
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed