Characteristics of Economic Recovery

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
May 19, 2009

Consider Sir Isaac Newton's third law of motion: "For every action there is an equal and opposite reaction." With this recession's crescendo of weakness likely in the rearview mirror, we now set our sights on the second half of 2009 and beyond; the consensus view is that a recovery is likely by the end of this year. As I've expressed before, I think the recession may already be ending, though the process is likely to be bumpy. That article highlighted what we currently see that indicates that the economy is starting its recovery—and this article highlights what the recovery might look like.

However, it will be some time before my view is either validated or proven wrong. The National Bureau of Economic Research—largely seen as the official dater of recessions—is typically late to the economy's funeral, but even later to its rebirth. As you can see in the table below, for the past four recessions, it’s been a full 15 months, on average, between actual recession end dates and the official NBER declaration. But pinpointing a recession's end is as much about semantics as anything else. For investors, using foresight can make the difference between profiting from the turn and sitting on the sidelines while it unfolds.

First, the caveats: The worst financial crisis since the Great Depression, combined with the effects of consumers paying down debt and saving more, will likely keep a lid on economic growth in the long term, and could mean the risk of a W-shaped cycle (a "double-dip"). A significant rise in commodity prices and/or longer-term U.S. Treasury yields could indicate inflationary pressures that would also curtail growth. A double-dip is precisely what happened in the early 1980s. But before we despair about that possibility, let’s home in on the first leg up and its likely characteristics.

Sooner and sharper?
Those of us (and there aren’t many) in the camp that believes the recovery could be sooner and sharper than most expect base our outlook on the waning effects of the Lehman Brothers collapse last September, which coincided with the seizure of the global credit markets and caused a devastating chain reaction in employment and production. The initial adjustment was fierce, and the economy went into utter lockdown mode.

We may now be starting the natural and necessary reversal of that plunge—where cyclical, shorter-term forces trump secular, longer-term forces, at least for a period. History shows us that, typically, the steeper the recession, the steeper the recovery. You can see this in the scatter chart down below—the slope of the pattern is pretty clear.

According to ISI Group, there’s an 80% correlation between the depth of the recession and the first year of growth. In the past, a –3% recession has typically seen 7% growth during the first four quarters of recovery. Unfortunately, the math for stocks doesn’t work as cleanly, with the relationship between bear-market depth and subsequent bull-market height much more tenuous.

Inventory/capital spending crush over?
Nowhere did we see the effect of the credit crisis more than on inventories and production, with record-breaking plunges in both. Now that industry has transitioned from a "just in case" inventory management system (having excess inventory on hand in case demand spikes) to "just in time" (keeping inventories as low as possible), the chart below shows how record-lean inventory levels suggest an imminent ramping-up of production—which would have positive implications for jobs (albeit with a lag). Auto inventories, admittedly, will fall further as production is greatly curtailed this summer, but aside from that blip, it appears the inventory correction may be largely over.

When businesses start adding back capacity, they signal that they’re thinking about hiring again. And with lending standards steadily improving from their depths earlier this year, capital spending looks set to bounce, as you can see in the chart below (in which lending standards are moved ahead two quarters to reflect the lag). Investment fell at a rate of 30% over the last six months, but now there’s hope.

Ned Davis Research notes a 0.76 correlation coefficient (1.0 = perfectly correlated) between lending standards and spending on equipment and software (the key component of capital spending). The pending turn is one reason for our "outperform" rating on the technology sector.

An emerging consumer powerhouse
There’s a global story brewing as well that ties back to the caveat of private-sector deleveraging in the United States. The U.S. consumer’s 25-year experiment in debt-fueled consumption may finally be over, but there’s another consumer waiting in the wings: Asia’s emerging economies are presently in the best position to take some of the global consumption power from the United States.

As depicted in the ISI Group chart below, during the past decade emerging Asian economies have built enormous current account reserves that could generate a new and powerful source of consumer demand.

During the aforementioned debt experiment in the United States, developing economies came into their own and have arguably been the biggest beneficiaries of globalization. Added together, developing economies today are larger than the U.S. economy. China, in particular, is seeing the effects of its stimulus programs manifested in four consecutive months of rising leading indicators and economists’ forecasts for GDP growth rising every day.

As we think about future investment implications, we may not have to look much further than the bull market(s) that preceded the current global bear market: commodities, currencies of commodity-producing nations, emerging-market equities and even U.S. equities (especially those with an export bias). The S&P 500® has seen its exposure to globalization increase, with foreign sales as a percentage of revenue for the index jumping from 33% in 1995 to 41% in 2008.

Even private equity is creeping out from under its rock. The industry stands ready to pounce on a recovery by pumping critical capital from its $1 trillion war chest (quietly restocked during the downturn) into the markets and economy in a likely new wave of deals.

The market: Reading the tea leaves
A massive leadership rotation is underway, and we believe that sector selection is becoming more critical. Economically defensive groups have gone nowhere during the past month, while formerly weak stocks (those with the poorest fundamentals and worst prior momentum) have exploded off the March lows. Don’t fret—such rotations are typically most violent coming off bear market lows, and the lowest-quality stocks rarely lead the market for long.

In an interesting note relating to Schwab Equity Ratings®, the preponderance of large-cap names among A-rated stocks—a virtual constant from late 2003 through mid-2008—has now reversed. The ratings don’t consider market cap in evaluating a stock’s attractiveness, and there haven’t been as many A-rated small-caps as there are today since the end of the 2000–2002 bear market.

Stocks over bonds
Let me conclude with a final implication of recovery. Many investors have been hoarding money in government bonds, and by the end of the first quarter of 2009, the total return differential for stocks versus bonds was at or near all-time lows (i.e., stocks underperforming bonds) over the last 10-, 20-, 30- and 40-year time frames!

Homing in on 20-year rolling periods, only twice in history have bonds outperformed stocks to this degree: through the second quarter of 1932 and through the third quarter of 1949. Bonds substantially lagged stocks in the five years following each historical peak in bonds-over-stocks performance. So we may be at a historic inflection point in the relationship between the two asset classes.

According to The Leuthold Group, which used annual compound returns, the S&P 500 was up nearly 34% five years after the 1932 experience, versus less than 5% for the 10-year Treasury bond. Five years after the 1949 experience, the S&P 500 produced a 23% return versus less than a 2% return for Treasuries.

In sum, stock markets globally have begun to respond to the prospects of recovery, with emerging markets leading the way. Indeed, we’ve had multiple rallies during this brutal bear market, but until now none has been accompanied by a turn in leading economic indicators. But now we see a break on the upside for commodities and Treasury yields, and a break on the downside for the dollar.

Review your long-term target allocations and consider rebalancing away from excess cash so you’re not sitting on the sidelines watching the recovery unfold. Looking back, excess cash was justified last year, but paltry yields and improving fundamentals suggest a less risk-averse strategy if you have a reasonably long time horizon.

Important Disclosures

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab’s outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any specific investor. They do not take into account individual financial, investment or other objectives. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. From time to time, Schwab may update the Schwab Equity Ratings methodology.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investments and strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All views and expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and are not intended to imply future results.

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