Wednesday, July 22, 2009

Will the stock markets bottom after the recession ends?

According to the market gospel, equities are supposed to bottom 6 months before the end of a recession. It is argued that since the stock market is a leading indicator, it anticipates the recovery in the economy and turns up before the economy does. People are advised to stay invested, given the difficulty in trying to time the exact bottom.

The 2001 recession is the obvious fly in the ointment. That recession ended in November 2001, but the equity markets didn’t bottom until 12-18 months later. While it’s tempting to reject it as a statistical aberration, I came across an argument which suggests otherwise, and this might just be the norm going forward.

In a nutshell, because of weak economic recoveries, the stock market bottoms will lag the NBER defined end-of-recessions. An excerpt from this excellent article titled “Debt and Deflation” better illustrates this point:

In all the recessions from 1967 to 1999, the NBER aligns its recession ending dates very well with the unified recovery in income, production, employment and sales. However, for the 2000-2001 recession the NBER call date for the recovery did not line up with these four coincident indicators. Although the recession officially ended in November 2001, employment and income had not turned higher. In fact, they did not trough until March and August 2003 recording lags of 16 and 21 months, respectively. Thus, the economy was only in a partial recovery, a situation that had huge stock market implications.

The S&P 500 Stock Price Index troughed prior to the end of all the NBER defined recessions from 1967 through 1999, in concert with the four key economic variables. However, in 2001 the S&P bottomed 15 months after the end of the NBER defined recession yet one and six months before the cyclical troughs in income and employment, respectively. In other words, stock prices anticipated the complete, not partial, recovery of these pillars of economic growth. Although all four of these indicators are still falling, the critical event for the financial markets will be when all four finally turn higher. If a complete recovery of these four variables is still far in the future, then the current gains in the stock market cannot be sustained, just as rallies were not sustained in 2001.

The recovery after the post-2001 recession was dubbed “the jobless recovery” because the uptick in the jobs data didn’t happen until 2003. US recoveries are getting longer and weaker. At some level this makes sense; as the economy became more service sector oriented it also became less cyclical then, say, a manufacturing economy like China. Add in things like just-in-time inventory management and the businesses could adjust inventories quickly to the end-user demand. (All these factors are straight from a class lecture). The Greenspan-Bernanke put further made the downturns mild in nature. The absence of normal downturns made the subsequent recovery slower and weaker.

Lakshman Achuthan had this interesting thing to say about the weak recoveries, and the implication for stocks going forward:

There are two secular trends which are problematic and should challenge stocks. Trend growth of recoveries, ever since world war II have been getting weaker and weaker. So our altitude is lower and lower. At the same time, the size of the cycle is getting bigger. Add these two things up, you get more frequent recessions and recessions bring with them new bear markets.

The implication of weaker recoveries on stock markets is often overlooked and seldom discussed. It might be time to toss out the old perception of stocks bottoming before the end of recessions.

Weaker recoveries, lagging stock markets, more frequent bear markets, structurally higher unemployment and interest rates. Equities will surely get re-priced. One more nail in the stocks-for-the-long-run coffin.

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