"Excess generally causes reaction, and produces a change in the opposite direction." ~ Plato
Humans like to watch for (and make decisions based upon) patterns. This behavioral trait is certainly no exception in the world of capital markets and economics. The most watched pattern at the moment might be the current and projected shape of the recession.
Economists like to describe the shape of economic recessions as V-shaped, U-shaped, W-shaped or L-shaped, the letter shapes of which reflect the respective form taken in a graphical illustration. It is important to note that economists have not proven to be forecasters by nature and that traders and investors in capital markets often believe the consensus view of economists to be more wrong than right.
A recent BusinessWeek article, The Recovery: It's The Herd Vs. History, noted that the average forecast of economists calls for modest growth in real gross domestic product of 2.7% over the next year. In fact, the NY Fed President, Bill Dudley, says there will be no V-shaped recovery.
History, however, suggests that deep recessions are followed by strong short-term recoveries -- stronger than economists are now forecasting. Additionally, the stock market and other indicators of future economic activity seem to be forecasting a V-shaped recovery:
As you can see, at least at the moment, the stock market, along with other leading economic indicators, is pointing toward a V-shaped recovery, which contradicts most of what conventional wisdom has been saying for several months. The same BusinessWeek article, by James C. Cooper, goes on to make a few other observations that counter current and recent expectations of economists:
...in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.
The average number of quarters for GDP to regain its business-cycle peak in the past nine recoveries [is 1.9 quarters].
Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.
The common argument [against a stronger recovery] is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit...
Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months.
My non-quantitative/behavioral/philosophical perspective is that one must be careful to look at any economic cycle, especially this one, as "average." At the same time, one must be careful to make the assumption that consumers, who make up nearly 70% of economic activity, will act according to scientific forecasts.
At present time, consumers appear to be more rational than usual: They are spending less than they earn and are largely avoiding debt. This would support the consensus view of economists that the recovery will not be V-shaped.
Complacency, however, must never be underestimated. As the memory of the financial crisis becomes increasingly replaced by months of economic growth and growing 401(k) balances, consumers will return to their irrational behaviors of spending more than they earn and funding their life today with tomorrow's money. This would support a V-shaped recovery.
"The difference between what the most and the least learned people know is inexpressibly trivial in relation to that which is unknown." ~ Albert Einstein
Simultaneously, one must consider the unknown and make a conscious effort to resist taking action upon the "easy forecast." When an expectation seems obvious or when an answer is easy to come by, the prudent minded person, given that there is time to pause, will make an honest effort to find reasons that they (and/or the herd) could be wrong. The easy forecast, especially at this time last year, was for an L-shaped recovery, which now is obviously not the case. Evidence also now reveals that this is no U-shaped recovery either.
A V-shape, however, can always be the beginning of a W-shape! As history repeatedly reveals, nature likes to hide!
To conclude, and to reiterate last week's point to resist the temptation to watch for patterns and act upon predictions, the prudent investor does not spend time trying to forecast the future direction of capital markets and the economy.
One must first consider their own "personal economy" and how to allocate financial resources in a way that supports life pursuits beyond money. Short-term market fluctuations are fodder for media noise -- not a basis upon which to form sound financial decisions.
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Related:
I could see a W happening, based on what Australia did two weeks ago. this was done not only to tame inflation, but maybe to get people to buy their bonds when the market goes down. If they keep raising their cash rate, consumers anticipate higher inflation which causes them to save more and will force Australia to raise their bond yields to attract investors. When the market crashes consumers are going to look for a safe investment--government bonds. Australia's high ytm+coupon will be the most attractive.
the AUD has been depreciating to others, but this will turn around once the market tanks.
I also like this premise because Australia said they plan on raising the cash rate even more, which to me signals the market is headed up for another intermediate term.
Posted by: andrewww | October 16, 2009 at 02:26 AM
andrewww:
Thanks for the Aussie insight! I'm no expert on spending and saving habits but I would guess the opposite result in America. If Americans anticipate higher inflation, they might be more inclined to spend (rather than save) so they can buy their goods now at lower prices!
Thanks again for the comment...
Kent
Posted by: Kent @ The Financial Philosopher | October 16, 2009 at 07:58 AM