From V to U or square-root – what does the shape of recovery look like?
Last week we had a Live Market Update and enjoyed presentations from two of Ned Davis Research’s often cited analysts Alejandra Grindal, Senior International Economist, and Ed Clissold, Chief US Strategist. One of the topics that came up was the possible shape of the recovery in the US market on the other side of a likely recession we are in now. They discussed square-root and U-shaped recoveries.
I wanted to review what that can end up looking like in reality as it can be difficult to imagine and project in terms of what we may have ahead of us in the market. Square-root and U-shaped recoveries are different in how they bottom but they are similar in the medium-term outlook. They share a general view that there will be slower economic output and payroll growth during recovery than just prior to the recession.
A picture is worth a thousand words
Many investors have gotten used to V-shaped recoveries, like the one we experienced in late 2018/early 2019. However, U-shaped and even W-shaped recoveries differ quite a bit. While no two recession/recovery phases are the same, there is always a lot we can learn from history.
V-shape recoveries tend to be quick and lead to new highs quickly. U-shape (and square-root shape) tend to look similar at the beginning but take substantially longer to reach new highs. W-shape is still a possibility given the real possibility if COVID-19 has a second phase that causes more economic pain.
U-shape recoveries have seen slower economic rebounds in both growth and payrolls than V-shape recoveries. This is also true for other economic factors like sales, earnings, and profit margins.
One thing that is remarkable is that for the S&P 500, the first 8 months of all recoveries tend to look similar. Therefore, it may be another 6 months or so before we really know what shape recovery we are having.
Caution should be taken as averages are not the same as rules. In the current environment, timing is murky at this point. However, if we do end up with a V-shaped recovery, we should begin to get confirmation within a couple months that we are heading that way.
I need to caution people from drawing too hard of a conclusion from this data because there are relatively small amounts of data involved in this analysis and every single recession has its own nuance. We prefer to view all and consider what the weight of the evidence is telling us rather than pick one thing that makes us feel good about our opinions.
There are two economic factors that are important in all of this: sales and earnings-per-share. Sales always track the economy no matter what type of recovery we end up having. Sales growth itself tends to decelerate even after a recession has ended but takes longer to trough in a U-shaped recovery.
If that were to happen this time, we would expect sales growth to remain negative until 2021. Another fact is that earnings-per-share (EPS) for both V and U-shaped recoveries have bottomed three to six months after a recession ends (with exception of 2009). Excluding 2009, U-shaped EPS growth did not catch up to V-shaped recoveries until 18 months after a recession. If we have a U-shaped recovery, we will not expect an EPS growth rebound until 2021.
As this recession is driven almost completely by COVID-19, we need to understand more about therapeutics, vaccines, and the reopening of the economy before we can tell if the rebound in the stock market will continue.
Any resurgence in the virus could mean that a more typical and slower bottom of a U-shape recovery is produced. If not, we would still anticipate a square-root shape where it mimics a V-shape recovery and eventually slows down as markets face the realities of higher debt levels and potentially slower demand from consumers who go back to work later than anticipated.
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