V - L - U - What Shape Will The Recovery Be?

Simon Maierhofer

'There is nothing so uncertain as a sure thing' said hockey legend Scotty Bowman.

The consent among Wall Street analysts and economists is that an economic recovery is just a matter of time. Many believe the recovery is just around the corner.

While the imminence of the recovery is a foregone conclusion, it has become a favorite pastime for many to figure out what shape the recovery will take.

A V-shaped recovery with a resumption of the bull market is obviously the investors' favorite. Other options in discussion are the L-shape, U-shape, inverse square root-shape, and lightning bolt-shaped recovery.

This article will analyze the different shapes of a recovery and, most importantly, whether a recovery is even plausible.

Just as a court of law would carefully evaluate all the facts pertaining to a particular case, we will address this subject from different angles. Whereas, the judge would make the final call in court, the stock market will have the last word in our discussion.

Credibility - chicken or the egg

A court of law would check the credibility of the facts presented and the credibility of the person presenting the facts.

After reviewing the numbers used as a foundation for an economic recovery, I am almost certain that a judge would ask, 'Where were you at the top of the market before the meltdown started? Where were you in March when stocks traded 30% below today's prices? If your numbers are so great, why weren't you able to warn us? Why should I believe you today?'

You can't argue with logic and those are all valid questions.

Analysts and economist, in the majority, were quiet right before the Dow (NYSEArca: DIA - News) and S&P 500 (NYSEArca: SPY - News) started their 50%+ breakdown. They were also quite silent just before the Dow and S&P 500 set up for a 35% rally. After a 30% drop from the high, and after a 30% bounce from the lows, analysts and economist have regained their 'magic powers' of confirming a mature and established trend.

Rather than confirming an established trend, the ETF Profit Strategy Newsletter is focused on identifying profit opportunities. Already in October 2008, the newsletter considered the financial sector (NYSEArca: XLF - News) to be a 'downward spiral with no stop-loss protection' and recommended short ETFs, such as the UltraShort Financial ProShares (NYSEArca: SKF - News) and UltraShort S&P 500 ProShares (NYSEArca: SDS - News).

The rally from the March lows has quickly converted fear into hope. The American Institute of Certified Public Accountants recorded an all-time record high of 83% pessimistic sentiment, in the first quarter of 2009. Since then, pessimism has decreased by over 30%.

Commenting on the results, Professor Mark Lang, Ph.D. says: 'There seems to be a broad consensus that the worst of the downturn is over for the US economy. On the other hand, it is disconcerting that, while managers are generally more optimistic than they had been, they appear to be conservative in their investment and hiring plans. Overall, the results suggest that we may have reached a bottom, but improvements in spending and employment are likely to be very gradual.'

A friendly trap

Professor Mark Lang sums up what many are feeling; the worst of the downturn is over. Certain consumer sentiment readings confirm this to be the general consent. The problem with consumer sentiment is its contrarian nature. Consumer optimism is often indicative of a market top, while consumer pessimism is indicative of a market bottom.

From the November 21st intraday low of 7,400, the Dow rallied roughly 1,600 points to 9,000, where it hovered for a few days. The Santa Claus rally, coupled with a positive first five days of the year (viewed by many as a barometer for the entire year), had pushed the Dow to new recovery highs and rekindled investors' thirst for equities.

Contrary to the general mood at the time, the ETF Profit Strategy Newsletter recommended the following on December 15th: 'Optimistic sentiment, which should be more visible above Dow 9,000, will give way to further declines. These should draw the indexes below their November 21st lows.' In February the target range for the low was adjusted to between Dow 6,000 and 6,700. This was to be followed by a 30-40% rally, the most powerful one since the 2007 all-time highs.

Almost literally, investor sentiment smiles in your face and stabs you in the back, if you allow it to. Don't rely on the prevailing mood of the day to make your investment decisions (unless it's contrarian).

Those who fail to learn from history...

This bear market has often been compared to the 1972-1974, or 1980-1982 bear. The 80's bear was fairly shallow with a 27% decline in the S&P 500 (NYSEArca: IVV - News). The 70's bear did send the S&P 500 tumbling by 48%.

So far, the current bear market has melted the Dow Jones (top to bottom) 55%. This exceeds the 70's and 80's bear, and makes them unsuitable for comparison purposes.

The only comparison that still holds is the 1929-1932 bear market, also called the Great Depression. The first leg down reduced the Dow Jones by 48%. Even that was shallower than what we've experienced just recently. From 1929 to 1932, the Dow staged five powerful counter trend rallies, ranging from 23% to 48%.

After every counter trend rally, investors were wondering what shape the recovery would take. Yet, there was no recovery. Each counter trend rally was followed by new lows. The bear market was not over until the Dow Jones lost over 89% of its value.

No recovery in sight

The chart below shows a graphic illustration of the different recovery scenarios. Even though ignored by the media, analysts and economist alike, the 'lightning bolt' scenario is the one supported by history and internal stock market indicators.

Some misconstrue investors' elevated risk tolerance as the symbol for a new economic cycle. Perceived lower risk large cap funds, such as the Vanguard Large Cap ETF (NYSEArca: VV - News) or iShares Russell 1000 ETF (NYSEArca: IWB - News), have been trailing behind small or mid cap funds, such as the Vanguard Small Cap ETF (NYSEArca: VB - News) or MidCap SPDRs (NYSEArca: MDY - News).

Mid and small cap funds fell harder and faster than large cap funds during the decline, so it's normal to see those compressed segments bounce back higher and faster. The same holds true for the financial and real estate sector, and their corresponding ETFs. Trusting in such make believe signals can easily turn out to be a Trojan horse. There are, however, reliable indicators that shed much needed light on the situation.

The big picture

Wall Street in general tends to ignore the merits of P/E ratios, dividend yields, and mutual fund's cash reserve levels. An analysis of major market bottoms, over the past 100 years, shows that the stock market has never bottomed unless those three indicators reach certain levels. Unlike much on Wall Street, those levels have not changed.

P/E ratios around 15, and dividend yields around 3.5%, are definitely not indicative of a market bottom. In fact, the levels are still far away from past rock bottom watermarks. Just as a farmer knows that the harvest isn't mature before late summer, savvy investors know that the stock market is not healthy unless those levels are reached.

The implications of the above three indicators are further confirmed by the Dow Jones measured in the only true currency - gold. Starting in 1999, the Dow measured in gold (NYSEArca: GLD - News) started its descent to new lows, and has thus mapped out the course for stocks in general.

The March and June issue of the ETF Profit Strategy newsletter includes a detailed analysis of P/E ratios, dividend yields, mutual fund cash reserves, and the Dow measured in gold, along with target levels for the ultimate market bottom. The 'verdict' is unanimous. There won't be a true recovery anytime soon. Hopefully your portfolios will pass the test of the ultimate judge - the stock market.


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