V, W, L, or √? and What it Means for Your Financial Future

September 30, 2009

In today’s volatile market, it can be hard to understand the logic and reason behind the seemingly whimsical swings in stock prices – or to know if there even is a reason. Investors are tired of hearing from supposedly educated people on television that our economic recovery (or lack thereof) can be captured in the letters you find in canned alphabet soup.

So What do These Letters Mean?
V-Shaped Recovery:
The stock market rebounds extraordinarily fast without retesting lows on its way to setting new highs. A great example would be the recovery following the Dot-Com Bust.
Causes: V-shaped recoveries often take place after severe panic selling or external shocks to the financial system. In the late 1990’s, the economy was booming because of the seemingly infinite potential of the Internet and strong spending on IT equipment in preparation for Y2K. The Federal Reserve had also been steadily raising interest rates in order to slow growth and suppress what it felt was a speculative bubble. After Y2K passed, growth slowed as companies cut back on spending because they already had everything they needed. This drop in spending rippled through the rest of the economy and the market began its descent. The strong rebound was the result of a excessively low interest rates which encouraged speculative investment in hard assets like real estate and the growth of the credit bubble which has recently burst.

V-Shaped Recovery

V-Shaped Recovery

W-Shaped Recovery: The economy bottoms and begins to recover, but falls again before returning to normal growth. This happened in the back-to-back recessions that took place from 1980-1982 in the United States.
Causes: W-shaped recoveries happen when the initial recovery is fueled more by inventory restocking than by growing demand or when the recovery is accompanied by high levels of inflation. Companies cut back production when a recession approaches, causing an initial drop in GDP. They eventually need to restock which causes a brief  jump in production followed by another drop before real demand begins emerging. Recoveries accompanied by high levels of inflation put pressure on the Federal Reserve to raise interest rates, which also can cause a second dip in GDP because high interest rates slow economic growth.

W-shaped Recovery

W-Shaped Recovery

L-Shaped Recovery: The stock market falls and does not return to a normal level of growth for many years, if ever. This type of recovery is most associated with Japan following the bursting of their asset-price bubble in 1990.
Causes: L-shaped recoveries are typically caused by either severe asset-price bubbles or high unemployment, also accompanied by inflation. Japan had been growing robustly from the end of World War II through the 1980’s. This created excess liquidity (too much money chasing after too few assets) in their economy, putting upward pressure on prices. When their bubble burst in 1990, it triggered a severe and lasting fall in the stock market from which they are yet to recover.

L-Shaped Recovery

L-Shaped Recovery

Square Root-Shaped Recovery: The stock market falls and then recovers quickly before plateauing or progressing at a growth rate that is lower than the prior growth rate. There are some economists who believe that the current credit crises may turn out to be an example of a square root recovery.
Causes: The initial drop in the market is usually caused by an external shock which causes panic selling in order to meet margin calls and fund redemptions. These forced liquidations drive the market lower than its intrinsic value which is why the initial bounce back upward is so forceful and doesn’t retest the lows. However, growth in the following years is constrained by weak credit and job markets as well as people continuing to save more and spend less.

Square Root-Shaped Recovery

Square Root-Shaped Recovery

More Importantly, What do These Letters Mean for You?

Even though so much hype goes into debating about what letter our recovery will look like, it is mostly irrelevant to the investment management process. We stand by our convictions and do not move blindly with the rest of the herd (you only need to look at what the herd did in 2008 to see why).At Pacific Mountain Advisors, we focus on equity market fundamentals, ‘big picture’ macroeconomic trends, and strategic asset allocation among sectors.

Our time tested investing discipline is designed to remove emotion from the equation by rotating client funds away from sectors that are frothy with speculation and into undervalued ones based on our blend of proprietary quantitative and qualitative analysis. Our methodology of locking in client profits on the way up during bull markets, while building exposure to “the next big thing” of tomorrow ensures that our clients are able to participate in bull market moves, while sidestepping the majority of the carnage from bear markets.

I hope that you have found this of value and I encourage all of you to leave comments/ questions below. Also, please feel free to email me with any other questions or topics that you would like to learn more about.

All the best,

Michael Meara