Market Recovery 101
Since our last update, much has happened in global investment markets and at least some of it has been good news. Since their previous peak in February, markets have lost upwards of 35% and have since retraced over 20% of those losses*. While we’re not out of the woods yet with COVID-19 still wreaking havoc on economies the world over, some recovery is always preferable to no recovery.
Much of the discussion between economists and, in turn, portfolio managers recently is in trying to predict the shape of the recovery from this recession. There are a number of potential models which we’ll shed some light on here: the L, U V, W and ‘Swoosh’ shaped recoveries and what they mean in the real world**.
*: S&P500 Price Return & TSX Composite Price Return
**: NWM: 5 Shapes of Coronavirus Economic Recovery
V-Shaped Recovery:
This is the ‘optimistic’ and best-case scenario after an economy or market sees a sharp downturn. Quite simply, this model proposes that the crash is a short-duration drop in GDP (economies) or stock prices (markets) that sees a subsequent and equal rise in rapid succession. We consider this a best-case because it means that, so long as we all close our eyes and ignore the discomfort of account values tumbling all over the world, we’ll open those eyes in a few months to see our portfolios reaching new highs as if nothing happened. A great example of this was the large drop in late 2018 that saw the S&P 500 tumble 15% in 2 months. The subsequent recovery was almost uninterrupted and new market highs were reached only 5 months after bottoming on December 3rd.
As is so often the case, best-case scenarios rarely come to pass and it’s our opinion (and those of most of the managers we follow) that we’re unlikely to see a true V-shaped recovery despite a healthy bounce back from the March lows over the last couple months.
U-Shaped Recovery:
A bit more of a realist’s perspective, the U shaped recovery says that we will see a sharp downturn in economic output (not always matched by markets) that will stay low for some time before we see a surging return to the previous highs. There are many variables that influence how a country fares in economic terms, but we generally refer to GDP (Gross Domestic Production – generally calculated as the total of all goods produced within a country) to compare how things are today to previous years.
Previous deep market drops in Canada such as seen between 2000 and 2005, were characterized by a U-shaped recovery. Things tumbled very deep, very quickly and stayed low for some time (nearly 5 years). After a while though, particularly with a change of government and policy direction in the US as well as booming commodity markets, we saw markets come charging back and emerged into roaring bull markets right up to 2008*.
While many economists consider this one of the more likely scenarios, we tend to disagree as U-shaped recoveries are more typical of ‘bust’ type recessions where an asset class such as Energy (in the early 1980s) or Technology (in the early 2000s) craters and takes a large section of the markets with it. The knock-on effects of these events, such as increased inflation, will usually result in the U-shape seen in markets during these recoveries. There are many contributing factors to this recession, but the primary driver is a total cessation of demand due to government intervention. As you’ll see below, we consider another scenario more likely.
*: S&P500 Price Return & TSX Composite Price Return
L-Shaped Recovery:
Next up, we have the pessimist’s outlook. An L-shaped recovery would involve the economy suffering permanent damage from the COVID-19 situation and would see GDP drop sharply and simply not recover over any reasonable time frame. This scenario isn’t without precedent – Japan experienced its ‘lost decade’ in the 1990s from an L-shaped recession where their economy experienced long-lasting damage from issues such as a credit crunch and liquidity trap (both scenarios that central banks are struggling to avoid around the world right now).
While certainly a potential scenario, this doesn’t seem as likely to come to pass in Canada due to aggressive fiscal and monetary intervention in all developed nations that are aimed specifically at preventing this sort of permanent damage.
W-Shaped Recovery:
A sort of hybrid between the U and V shapes, a W shape is exactly as the name implies – a sharp fall followed by a sharp rise, then sharp fall, then sharp rise. Another (less tasteful) name that is tossed around for this is sometimes called a ‘dead cat bounce’, where markets or economies fall, rise a bit, then fall right back to the previous low before finally climbing out of the lows.
U and W shaped recoveries share a lot of similar characteristics in that they both imply that damage is never permanent and that we’ll see new highs eventually. A W shape differs primarily from the U shape in that the W model has above average up and downward volatility. Although it’s anyone’s guess whether the recent climb is the central peak of a W shape, we’re of the opinion that until a healthcare solution is created that markets will continue to oscillate up and down before finally breaking back above early February highs. Because it’s difficult for markets to ‘price in’ this sort of uncertainty, we consider that this is more likely to be the case than a strict U-shaped market pattern.
“Swoosh” or Check Shaped Recovery:
Almost everyone is familiar with the ‘Swoosh’ shape that is the foundation of Nike’s branding – a sharp fall followed by a long, slow rise back up to the peak. This model was proposed to account for how consumers may, after experiencing a substantial loss of income due to the COVID-19 shutdowns, be hesitant to spend money quite as freely as they were doing prior to the pandemic. We’ve all had conversations with friends, family and clients about how vacations, renovations and other large planned expenses might need to be postponed until we’re through this. Since money spent is how the economy flourishes, this hesitation will in turn result in a slower climb back than we might see in V, U or W shaped recoveries. All things being equal, the model still implies that the economy will eventually come back to normal.
Because much of the reduction in economic output worldwide is due to governments mandating shutdowns to combat the spread of a pandemic, this type of recovery is considered the ‘base case’ scenario by many economists and managers – it’s unlikely that economies will reopen all at once like some titanic ‘ON’ switch was thrown. Proponents of the Swoosh model anticipate GDP and markets staying low for some time, potentially 18-24 months, before rising up and out into a new expansionary phase.
This ‘jives’ with Keynesian economic theory regarding business cycles and represents, in our opinion, the most likely way this will play out in markets. We’ll likely see some characteristics of the W shape (spikey volatility as markets price in uncertainty) but the long-term ‘shape’ should resemble the same logo you see on your running shoes.
In Summary:
The thing with economic models is that no one model has ever proved perfectly predictive for every scenario. Generally speaking, they’re only truly useful when analyzing what has happened in the past – it’s easy to point at 2008 and say ‘Oh! There’s the Swoosh shaped recovery they were talking about’ or draw a ‘U’ on charts of the 2000-2005 recession. It’s also easy to forget that analysts looking at data in late 2008 and early 2009 were pretty darn sure that they were seeing the start of a V or W shape instead.
Without the benefit of a crystal ball, we take a cautious outlook in saying that there will be some long-lasting damage to the Canadian economy, particularly for small to medium business without huge cash reserves, but that the country as a whole is not likely to be sunk by this crisis and we’ll eventually come out the other side. Similar situations will likely play out in other developed economies, although with different magnitudes and timelines.
As always, if you have any questions or would like to discuss our recovery expectations further, please do not hesitate to reach out.
