There has been a lot of chatter lately about whether the economy and the stock market will resemble a “V” or a “W” shape.
However, neither a rapid return to the highs of the 2007 (the “V”) or a snap back to the lows of March (the first three-quarters of the “W”) seems likely to me over the next few months.
Case against the “V”-shaped recovery
Our 10 percent unemployment rate is too high: Since the recession began in December 2007, 4.7 percent of all jobs, 6.46 million, have been lost. In percentage terms, the loss is about twice what’s typical in a recession, and it’s the worst in any downturn since 1950.
The Great Deleveraging: The household debt burden reached a historical peak, at 133 percent of household income, in late 2007. Household dollars that several years ago would have been earmarked for new discretionary spending are instead being diverted to pay down the hangover of old discretionary spending.
No real stimulus: Fifty-seven percent of Americans recently told the Gallup organization that the federal stimulus package has had no effect or has made the economy worse. Eighty-one percent believe that it has not benefited them.
Case against the “W”-shaped downturn
The Fed: Fed Chairman Ben Bernanke now has a firm grip on monetary policy and is running the printing press as fast as he can through the Fed’s “quantitative easing” program.
Forced liquidation has stopped: In the fall of 2008, much of the dramatic selling was the result of forced liquidation of hedge funds and other financial institutions that had made leveraged bets on the market. This forced selling pushed markets to overshoot on the downside. This forced selling has ended and will likely not return in the near future, as post-2008 leverage levels have dropped.
Panic has subsided: We find ourselves at a pretty unique place. Things are not really much better, but in some sense they are not as bad as they were. I guess the reasons to panic are all relative, like most other things.
Given all the factors listed above on both sides of the argument, investors should be keenly aware that the Fed is far and away the most important one on either list. The Fed has been actively engaged in “quantitative easing” for last several months, which has almost single-handedly propped-up the economy.
In March of 2009, the Fed announced plans to purchase $300 billion of Treasury debt by September through quantitative easing and to more than double its purchase of mortgage-related debt to $1.45 trillion. Recently, the Fed moved the completion date for Treasury purchases to the end of October.
The big question now is whether Chairman Bernanke and the Fed will continue the quantitative easing program after October. If they continue the program, the longer-term result could be more asset price bubbles, or even hyper-inflation. If they discontinue the program, the economy may falter again.
I believe your investments and their real and absolute values will be more affected by the Fed’s October decision on quantitative easing than anything else. The Fed’s decision will affect the dollar, inflation, Treasury prices, asset prices, etc.
However, with no clear signal on what the Fed will do, diversification in your portfolio is now more important than ever. And, as I mentioned in my April article in The Lane Report, true diversification requires negative correlation, not simply spreading your money among different asset classes.
So, don’t be afraid to buy stocks in the sectors and countries you believe will do well and sell the stocks in the sectors and countries you believe will do poorly. This should protect your portfolio no matter what the shape of the recovery.