August 31st, 2011
What is a W shaped recession?
I am increasingly concerned what’s happening in the USA and across Europe and its potential impact for the UK economy and the London stock market.
The current economic and financial turmoil seems only to be getting worse.
You should be asking yourself: Are we heading for the second leg down?
W shaped recession - recovery: an introduction
A W shaped recession is often referred to as a double dip recession or the second leg down of a “V” shaped recovery. It occurs when the economy has a recession, emerges from that recession with a short period of some growth, but quickly falls back into recession.
Generally a double dip recession only occurs every 30 or 40 years, or so. The last one was in 1974/1975 - previously in 1937/38 and 1930-32. We are clearly one due!
The term ‘W' is slightly misleading. The economy doesn't normally follow exactly the letter W - down, up and then down, up again.
During a W shaped recession the economy climbs after going into recession, but instead of going back down immediately, it flattens out for a period. Then it dips a second time before a full economic recovery.
That's at least the theory!
Where are we in the current W shaped recession?
The shape of a W shaped recession - recovery tends to unfold in five distinct steps, including:
- The first leg down
The first part of the “W” is a gradual decline of over 50% across most stock markets.
Between 2007 and 2009, the economy steadily declined, with the stock market going down at a "45 degree", to drop circa 60% over two years, with the FTSE100 bottoming out at 3500 levels. This is followed by . . .
- The bounce back
The second part of a W shaped recession - recovery sees the stock market bounce back and, often, the economy recovers somewhat.
This usually occurs within a six month period immediately following the down phase with stock markets recovering at least by more than 30%.
Stock markets went south until March 2009, a significant two-year drop. Then the markets bounced for six months till September 2009 when stock markets where approximately 60% up.
Since that time, we've been in what economists call a ‘hesitant, uneven recovery', in other words a relatively ‘flat' market.
- The drag
This is the part of the W shaped recession - recovery where the market bounces off the bottom but drags out in a flat period - representing the middle part of the “W”. Rather than any intermediate ‘tops’ and ‘downs’, this is usually a rather flat period that can last six months, two years or even longer.
During this period many CEO’s, as well as many investors, often make big mistakes, thinking that the economy is on its way to recovery when in fact it just goes sideways.
- The second leg down
The second leg down occurs at the end of the “muddling through phase”.
It is for everybody clearly to see that the “expected” recovery is illusionary. Consumer confidence is likely to getting worse. Job prospects are low. The general mood is down. We may well be at this point now.
This is the moment when many investors finally realise that a double dip recession is all but inescapable - a major sell-off takes place, taking everything with it down.
During the second leg down, uneducated investors often think that the stock market is returning to the previous down phase and start selling indiscriminately – the capitulation phase is nearing.
What is really happening is that the markets are just retracting to lower levels waiting for the next upswing to start.
- The up leg
Is it possible for a stock market to go up while the economy goes down?
It’s not only possible but also probable. A perception of improvements in either trade or budget deficits would change the mood of investors that would spur a strong stock market rally.
Growth shares trading at price earnings levels well below 10 or dividend paying shares trading at (substantially) below historically undervalued levels are likely to be early indicators that a substantial bounce is on its way.
A new period of growth will establish itself, but, this time round, I expect only when meaningful reductions in budget deficits are implemented and trade deficits start to improve - by then the new bull market will be in full swing.
Leg up or down? How to profit?
Some commentators have predicted the final leg down in the current W shaped recession to start in September 2011, for six months, which takes us through to about March 2012. From March onwards they say the economy will start growing again.
If you assume growth for between five and seven years, the average life cycle of an average economic boom, that takes us all way through to somewhere between March 2017 and March 2019.
But there is also a worst case scenario. Other commentators are forecasting the end of the flat period as June 2016 (Elliot Wave theory). If you believe this date for the next boom, and say it'll last seven years, we're now into 2023. So, somewhere between 2017 and 2023 is the height of the next boom.
Your guess is as good as mine!
In terms of wealth creation, that next boom is critical for you as a long term investor. In particular if you are in your 40-50ties, it becomes the most significant period of your life. It's when you can create the most wealth possible from your existing investments to retire on.
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Until next time.
Early Retirement Investor.com
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