Economic Recovery Will Come in Two Stages

 |  Includes: DIA, SPY
by: John D. Frankola

After completing the first week of November, the stock market remains battered, hovering just above its recent lows. Last week the S&P 500 Index fell 3.9%. Volatility remains at record levels.

The magnitude of the current market correction has done much to dishearten the majority of equity investors. With the major stock indices trading more than 40% below their 2007 peak, most investors have seen a substantial drop in the value of their portfolios.

While a recession has not been officially declared, the recent weak economic statistics as well as the reported third quarter results for U.S. companies are indicating that the U.S. is already in the midst of a recession.

For most companies, business held up very well until September and then abruptly stalled. While the slowdown was likely due in part to the inability of some consumers and businesses to obtain credit, it was clearly exacerbated by a sharp decline in confidence that occurred following the demise of Lehman Brothers, Wachovia, and AIG, all in the last two weeks of September.

On September 18th, the Treasury Department and Federal Reserve proposed a broad rescue plan for the financial system. The heated debate that followed, the predictions of a possible depression if nothing was done, and the spread of the credit crisis overseas apparently caused a virtual halt in commerce that carried into October. The vast majority of companies that reported third quarter earnings have lowered their guidance for 2008’s fourth quarter and all of 2009.

The irony is that the rescue package, which was intended to support the financial system in the hopes of averting a recession, might have actually pushed the economy into recession by creating a sense of crisis that has caused individuals and businesses to defer all but the most necessary purchases.

So that’s the bad news - we are likely in a recession. In addition, economic conditions will probably get worse before they turnaround.

Does this mean that stocks are headed lower? Not necessarily.

The good news is that the credit markets are showing signs of improvement. In addition, lower interest rates and the government rescue plan should eventually contribute to an economic recovery.

While the timing of the turnaround is impossible to predict, the likelihood of an eventually recovery is very good.

This recovery will likely come in two stages. The first stage should be an upturn from the current oversold levels. A large part of the decline in stock prices has been related to panic selling and forced liquidations by hedge funds and mutual funds. The forced liquidations occur when investors withdraw their money from funds, which then compels the managers of those funds to sell securities to raise cash for withdrawals. Panic selling and forced liquidations represent selling without regard to the underlying value of the company. Once this type of selling subsides, stocks should return to a more rational valuation as long-term investors seek bargains. In the four bear markets since 1980, the S&P 500 Index has advanced an average of 23% in the 60 days following the bottom, as stock prices recover from oversold levels.

The second stage of price recovery will materialize once the bad news begins to diminish and investors begin to see signs of an economic recovery. Generally, this point is usually midway through the recession. We are definitely not at that point yet, but it could occur within the next six months. In all likelihood, unemployment will continue to increase as companies cut expenses. At some point, lower interest rates, lower prices, and pent-up demand will begin to turn the economy around. In addition, we are likely to see a stimulus program introduced within the next several months. (Sunday, China announced a stimulus package, which should help U.S. exporters.)

So while it is still difficult to say whether the market has made a bottom and a recovery has begun, it does seem that stocks are very cheap based on their long-term fundamentals. When valuing companies based on their sales, earnings, cash flows and long-term growth rates, they appear to be relatively inexpensive compared to historical measures. Although the current stream of news is extremely negative, stocks appeared to be positioned for strong returns over the next one-to-five year time frame as the economy recovers.