Stock Market Recovery

V, W or Square Root?
What will happen?

Bobby Quant – Video 2 – Script – June 6, 2020

1,657 words at 130 words/minute = 13 minutes

What will the economic recovery from the COVID-19 pandemic look like?

There’s an alphabet soup of possible outcomes for the economy and now one
mathematical symbol, too.

Some analysts expect the shape of the stock market recovery to resemble a “V”:
growth rocketing straight up and to the right after nearly a 2 month shutdown which
looks to be happening as the markets are only have 8% more to go. A “W” recovery
suggests a double-dip recession.

Now, we can add a square root to the alphabet soup mix which some analysts are
forecasting. If you thought math was tough, the economic recovery from a square-root
symbol won’t be pleasant news. Famed investor George Soros may have been the first
to use the Square Root recovery. In 2009, just after the stock market had bottomed and
a few months before the official end of the 2007-2009 recession, Soros in an interview
with Reuters said that the economy would naturally bounce a bit after it hit bottom, but
then would “settle” into a prolonged period of subpar growth – a “lasting slowdown” that
would look like an “inverted square-root sign.”

Bring up the picture of the COVID-19 Square Root Recovery?

This is a bit gloomier than the scenario visualized in this chart from the Oregon Office of
Economic Analysis which shows a few options for the trajectory of the economy.

The dotted line on the right is worth paying attention to, because , while it signals
growth, it also suggests it could take some time for a growing economy to reach the
same baseline as before the shock that caused contraction.

It is that slower-for-longer where the stock market continues to rise on a flattening of the
COVID-19 curve and hopes of new treatments and/or a vaccine. Absent the high-
efficacy vaccine, we can expect the recovery to settle into the “new normal” of lifted
stay-at-home orders, but a cautious, if not unemployed consumer.
The big question is as US equities climb back towards pre-crisis levels is whether the
market has lost its bearings. The macroeconomic indicators and company-level
earnings is not just bad, but historically so, and it seems to make no sense that markets
should be rising, when consumer confidence and spending are tanking, the ranks of the
unemployed rising and economists are predicting impending doom.

There are some market gurus who are pointing to the disconnect that the markets are
just wrong and that a major correction is around the corner, but their credibility is
undercut by the fact that many in this group have been forecasting this correction for the
last decade.

From February 15 to March 20, there was a steep drop with almost every equity index in
the world down between 30-40%. The Chinese markets were the exception with a bear
market compressed into a short five weeks. Since March 20, is has been not just an up
market, but one that has climbed steeply. The S&P 500 which dropped almost 34%
between February 14 and March 20, had recouped most of the losses by June 5 th and is
now down only 8% from where it was February 14.

Two emerging market indices, the Bovespa of Brazil, the Sensex of India and one
developed market index, the CAC (France), have still lost more than 20% of their value
over the period. The immediate effect of the crisis was a flight to US treasuries, where
yields dropped across the board. Almost all of the yield drop occurred before March 15,
when the Fed announced its quantitative easing actions. The fear factor in the first few
weeks that caused the flight to treasuries also pushed up the default spreads on
corporate bonds.

There was a dramatic surge in the spread between February 14 and April 3, with a
tripling in the spread on BBB rated bonds. Corporate bonds seem to have entered a
period down significantly from their highs in early April.

Oil and copper are two commodities worth tracing to measure how a global economic
slowdown is affecting prices. Copper prices are down about 7% on June 1 from
February 14 levels but that is an improvement from the almost 14% drop in mid-March.
The oil market has had volatility that cannot be fully explained by the COVID crisis, as
oil prices plunged in late April, with West Texas crude dropping below zero on April 19,
but even oil prices have seen recovery in the last few weeks.

Gold which is a crisis asset of long standing and bitcoin a new entrant are worth looking
at as well. Gold has held up and is up just over 9% in the weeks since February 14, but
bitcoin has acted more like a risky speculative investment that a crisis asset, dropping
more than 50% by mid March before recouping most of its losses as equities came
roaring back in April and May.
In terms of geography, emerging markets have shown bigger declines in percentage
terms over the entire period. While market behavior was characterized as chaotic in the
first few weeks, this is clearly a market that has been orderly in how it hands out
rewards and inflicts punishment. The health care sector, technology and consumer
good show much less damage than the rest of the market. Even though the overall
market may have recovered much of its losses, value has been reallocated from
financial, real estate and energy into health care and technology. In the last few weeks,
some of the best performing industries delivering positive returns have been software,
precious metal, biotech and healthcare info/tech all posting returns exceeding 10%
since February 14.

As markets have recovered from their mid-March lows, there are many who are puzzled
by the sudden rise. For some, the skepticism comes from the disconnect with
macroeconomic numbers that are abysmal, as unemployment claims climb into the tens
of millions and consumer confidence is near historic lows.

The idea that stock markets and economies are closely tied together is deeply held,
simply because it appeals to intuition. How can stocks keep going up if the economy is
doing badly? While the right answer is that they cannot, there are three factors that
may delink the two.

1. The first is that stocks are driven by earnings, not real growth in the economy or
employment. While companies can continue to generate income, even in
stagnant or declining economies, you may see stock prices rise.

2. The second is that the “economy” that stocks are tied to does not always have to
be the domestic one, since globalization has made it possible for company to
continue to prosper in slow-growing economies.

3. The third is time. Since stock markets are prediction machines even with a lot of
noise and mistakes, there will be a lag of months or longer in the link between
markets and the economy.

In an analysis of the data of US stock market returns against real GDP growth in the
United States, there is almost no correlation between stock returns and real GDP
growth. If the relationship between stock returns and measures of economic activity is
weak, as both logic and the data suggest, it should be even weaker right now, where
measures of economic activity are attacked by the crisis-driven shutdown. To those in
the investment community who are shocked by the latest economic numbers, there is
almost nothing of use to investors from poring over current macroeconomic data, which
is one reason why markets have started ignoring them. This will however change as
the economy starts to pen up again and the markets start looking at the data for cues on
how quickly it is coming back to life.

Every investor has a narrative about how the economy and markets will evolve over
time. Markets reflect a collective narrative across investors, and there are time when an
individual will be at odds with that of the market. It is during those times where there will
be an urge to label markets as crazy or irrational and to view your self as the last sane
investor left on the plant. Projecting personal fears and hopes on to the market and
then getting angry when the market responds differently is a recipe for frustration and
dysfunctional investing. That is not to say that markets cannot be wrong, but even if
they are, a dose of humility is always in order, and there is always something that can
be learned from market movements. Right now, it is true that markets are more upbeat
about the future than most economists and market experts, but given their relative track
records over time, are you really more willing to trust the experts over the markets? It is
not the wisest decision to do so.

On trying to predict what will happen next or to forecast the future, the following are
some of my favourite quotes:

Forecasts usually tell us more of the forecast than of the future.

Warren Buffett

I never think of the future – it comes soon enough.

Albert Einstein

Those who have knowledge don’t predict; those who predict don’t have knowledge.

Lao Tzu

People can foresee the future only when it coincides with their own wishes, and the
most grossly obvious facts can be ignored when they are unwelcome.

George Orwell

Forecasts create the mirage that the future is knowable.

Peter Bernstein

The future you shall know when it has come; before then forget it.

Aeschylus
No amount of sophistication is going to allay the fact that all of your knowledge is about
the past and all your decisions are about the future.

Ian E. Wilson (former Chairman of GE)

We have two classes of forecasters: Those who don’t know – and those who don’t
know they don’t know.

John Kenneth Galbraith

So, what will happen? V, W or Square Root Stock Market Recovery. I seem to be in
good company in my belief that the future is unknowable.