The 'W' Shaped Recovery: How to Position Your Portfolio

Over the past two months the stock market has seen an explosive rally of roughly +40% from trough to peak. The rally was ignited by technical buying off an extremely oversold condition, however the move grew legs on the back of government policy announcements such as a ramp-up in quantitative easing, positive comments from the banking sector, and a deceleration in the deterioration of many macroeconomic data points.

This “improvement” in macroeconomic data was championed by stock market bulls as an early sign of an economic bottom because after all, an object in motion typically decelerates before it can actually reverse. Of the four influences listed above, the macroeconomic data points offered the only tangible fundamental underpinning for the rally (technical buying, printing money, and P.R. spin campaigns from the banks do not result in sustained economic growth).

The market took these data points in euphoric stride and bid up prices across the board, the buying fueled more buying as many stocks broke above their respective moving averages. Investors emboldened by the prospect of an economic recovery flocked to assets that would provide the most bang for their buck, in other words assets that would perform the best should the economy strengthen, leading them into riskier assets more levered to the economy. While perfectly rational behavior assuming the economy is actually on the road to recovery, it led to a wide divergence in the performance of riskier assets relative to their lower-risk counterparts. The below charts show this divergence.

S&P China Index (GXC) vs. S&P 500 (SPY)

click to enlarge

Consumer Discretionary (XLY) vs. Consumer Staples (XLP)

High Yield Bonds (JNK) vs. Long Term Treasuries (TLO)

Party like its 1933?

While the rally was robust and helped repair some battered IRAs and 401ks, the same macroeconomic data touted by the bulls is now suggesting the economic “improvement” (I use “improvement” because nothing actually improved per se, it just became less worse on percentage change basis, us neurotics on Wall Street are myopically concerned with year-over-year changes) was nothing more than a head-fake, meaning the bounce seen in March is being followed with further deterioration. Stock market bulls were betting on a “V” shaped recovery, in other words, a very brief time spent at trough levels followed by an upward trajectory in the economy. However, recent economic data points are suggesting the recovery is more likely to be “W” shaped, meaning the rebound off of the lows will be followed by another leg down. The “W” shaped recovery is especially dangerous to investors because it lulls them into a false sense of optimism (+40% rally) only to be followed by another leg down, which it appears we are now on the precipice of. Should this prove true I think it is reasonable to expect most, if not all, of the gains from the recent rally to be wiped out.

Let’s take a look at several indicators of macroeconomic activity. The common theme here is the increased likelihood of a “W” shaped recovery as opposed to the “V” shaped recovery that the recent rally seemed to be implying.

American Trucking Association Tonnage Index:

The ATA is the largest national trade association for the trucking industry, they calculate the tonnage index based on surveys from its membership and has been doing so since the 1970s. According to the ATA, trucking serves as a barometer of the U.S. economy, representing nearly 69 percent of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

Employment:

Below shows the year over year change in the US Employment rate as well as the year over year change in the Monster.com Employment Index.

It is also interesting to note that as bad as the employment picture seems to be right now, we are still not even at the average unemployment level seen at the bottom of a recession.

Hotel Rate and Occupancy Survey:

In the hotel industry RevPAR, or revenue per available room, is the commonly used metric for industry performance. Hotel demand is a decent proxy for both business spending and consumer discretionary spending.

Port of Long Beach Import Cargo Shipments:

Long Beach is the second busiest port in the US and 15^th busiest in the world.

How to invest?

These macro economic data points combined with the market’s recent price action suggest it is time to hunker down and get defensive again. Smart money should be selling, either outright if you have been long or possibly even look to go short, the high-risk and highly economically sensitive stuff that has run up hugely during this head-fake.

A few names to consider: ACF, DDR, MGM, BARE, GMCR. All of these have had huge price moves that do not appear to be rooted in fundamental business improvement.

On the long side, investors should look to take a more defensive stance, which includes lowering net exposure and raising cash positions. Several defensive stocks that should outperform the market include:

Corrections Corp (CXW): Private prison operator, favorable industry growth, pricing, and supply limitations. Demand inversely correlated to the economy (less prosperity= more crime).

Service Corp (SCI): Funeral home and cemetery operator, consistent demand independent of economic activity. Potential for operational improvement.

Chiquita Brands (CQB): Fruit and vegetable producer, staple products, favorable pricing environment.

Iamgold (IAG): Gold mining company, attractive valuation, highly levered to an increase in gold prices.

Disclosure: Long CXW, SCI, CQB, IAG

Comments

[rick12345:]

I concur with your reasoning, however no amount of data will convince these stubborn (if not ignorant) bulls that the current rally is for real. In fact they would have you beleive that Dow14,000 by years end is inevitable.
Like most politicians they are choosing to ignore certain bubbles in a desperate hope that they will magically disappear. These include an explosion in the amount credit card debt and the subsequent rise in default activity that will inevitably occur ; The commercial real estate market which is threatening to implode any time soon ; soaring inflation in years to come ; astronomical increases in national debt (the govt can't just borrow/print money without repaying it) ; rising unemployment followed by increasing taxes once the unemployment rate eventually begins to drop ; an increasing concern worldwide about americas ability to repay its foreign debt along with a falling dollar.
These are just some of the problems we face before we can assume a significant recovery. Contrary to what you may beleive, they are not "doomsday" predictions which may or may not occur. They are real and cannot be brushed under the carpet. My guess is that this whole mess will take at least 10 years to clean up. Au revoir, I'm moving to Europe soon.

May 19 08:12 AM

[The Silver ...:]

We have our W shaped recovery since equities have been in a bear market since 2000. A double bottom in 2003 and 2009 seems a launch pad to me.

May 19 08:29 AM

[AndrewBaker:]

A good article, showing clearly and unemotionally relevant numbers in chart form that indicate we are still in a down mode. It will be hard enough in the future to maintain one's present savings, without the hole in them that the next downturn will make. For every thumbs-down the bulls gives me here, they will suffer a commensurate drop in their own portfolios come the reversal, which is being delayed by propaganda and other manipulations, but which will come before the end of summer, if not this month or early June.

May 19 10:52 AM

[joes:]

This is as good of a guess or opinion as many others I suppose, but this comments was revealing, "
This “improvement” in macroeconomic data was championed by stock market bulls as an early sign of an economic bottom because after all, an object in motion typically decelerates before it can actually reverse."

The tendency of individuals to apply physics to a psychology driven quantity like the market has been shown to be a major source of errors in logic, causing people to lose a lot of money, please choose the spots where you suspend reality and start making up new "laws" to validate your position.

The tip to invest in highly leveraged gold after the largely irrational run up of the last few years is an interesting bit of advice also. Can anyone explain why people are buying gold other than John Paulson has increase his gold holdings?

May 19 10:53 AM

[Steven Hansen:]

the ATA trucking data is too old to be of much use. the container counts are remaining in a tight seasonal range showing a bottom.

if you are thinking i am disputing what has been written - i am not and agree with the article. my point is simply that we are approaching a bottom, and i suspect next quarter we may see improvement in the data. then i believe sometime next year we might see another leg down.

May 19 11:05 AM

[Tom Armistead:]

I agree with the concern at the weakness of the economy and the possibility of the W shaped recovery, but I think the trip down to 666 was driven by the belief that the Fed, Treasury, and politicians didn't have a handle on how to fix the problems.

The stress test solidified the belief that the USG could control the crisis.

To trigger another downward run might require some sort of an aftershock, another implosion or incident suggesting the authorities don't have the ability to create a recovery and prop up weak institutions indefinitely.

May 19 11:58 AM

[henarl:]

Problem with the W recovery prognosis is that it ends with an up leg.
I suggest that M is the more likely scenario for the foreseeable future.

May 19 12:26 PM

[Larry House:]

We will be lucky to have a sustainable recovery of ANY shape!

May 19 02:03 PM

[j_remington:]

W it is and will be.

May 19 03:12 PM

[Ricard:]

I like Grantham's 'VL' recovery. A fall, a rise, a fall, and a lower plateau. This happens to be the same pattern as Soros's inverse square root recovery. To assume a second rise is to assume that everything's ok, which by the data points in this article, imply that it's not.

May 19 03:33 PM

[Andrew Vickers:]

RE: "The tip to invest in highly leveraged gold after the largely irrational run up of the last few years is an interesting bit of advice also. Can anyone explain why people are buying gold other than John Paulson has increase his gold holdings? "

Because there is no sure bet, so people are hedging.

China is cannibalizing its foreign reserves to launch its own domestic stimulus program and will have a limited demand for USD denominated debt. They may simply try to spend the dollars they get before they are worthless. Japan is facing public outrage over the prospect of buying more US Treasuries. The other reliable Asian purchasers are going to have limited desire to buy our debt due to a combination of purchasing power risk and a sense that they cannot keep the giant Ponzi scheme of US Public debt going without China and Japan.

That means: recession or no, functioning credit or no, looming Option ARM and CRE collapses or no, interest rates go up up up (killing bonds and credit) or the dollar collapses. There's no rabbit that Timmy or Helicopter Ben can pull out of their hats. If you hadn't noticed, the US Government is already just about "all-in" and we've only just seen the flop.

So what are older people, who have already been ravaged once and cannot afford to put everything into equities in case it is a W, to do? Have some equities. Have some bonds. Have some cash equivalents. Have some energy. And, have some gold. Because, quite honestly, anyone clever enough to think they know what's coming is really a bloody moron and doesn't understand just how many fracture points our new tightly coupled global economy has and how many different, minor, and seemingly unrelated events could push everything one way or the other. We've validated chaos theory.

We could have inflation or we could have deflation. We could have a V recovery or we could have a W recovery. John Calvin didn't design the markets. There is no predestination. The outcomes will be determined by actions that have no yet occurred. Some will be best guesses by decision makers who have some understanding of what their actions will entail. Others will potentially be actions by people who little to no idea what the impact will be on the global economy and may not even care. Normally momentum accounts for a lot, but when you seemingly approach slack tide, as we are, who knows.

Some of you will stack your bets and lose your asses. Some of you will place your bets, leverage and win big and then declare in a couple of years that you are geniuses. You know what they say, though, it's better to be lucky than good.

That's my guess as to why people are buying gold. Because they have a good idea that they have no idea, while the professionals who think they have a good idea have no idea and don't know it.

May 19 04:50 PM

[Alan Young:]

The economic data are not in dispute. But stock valuation is relative. We had essentially the same economic problem last summer, with the $SPX at 1250; that was full-scale denial. If we had overcome the denial and re-evaluated the stock market, WITHOUT the panic following the Lehman meltdown, a descent to 800 or 900 would have been considered a severe correction, proportionate to the bad economic problems. But coming UP to this level arouses more suspicion. You think the bad economic data isn't priced in; I wouldn't be so sure.

Some other points to consider:

(1) The worst stocks rallied most because they were the most oversold, not because their shortcomings are being ignored. This is not, IMO, a good indicator of the quality of the rally.

(2) The market is not responding ONLY on emotions and hype; market makers (at least GS, if not others) are jamming buy orders in to push prices up at tactical moments. It would be treacherous indeed to trader, much less invest, without being aware of this. But it's also unwise to treat the resulting price spikes as mere delusion. There is real money to be made in the bear-rally trade.

Personally, I think another leg down is a realistic expectation. However, it's more important to trade on what the market is actually doing than to be "right" about what it is supposed to do next. We don't know for sure what will happen; for all we know, the "greater fools" who buy "overvalued" stocks today might be the winners at the end of the month, or the quarter, or the decade.

May 19 08:46 PM