Broker Talk: The Recovery Will Surprise You

Investors are still jittery about the market recovery. But considering history, some brokerages say the outcome could be better than they think.

Who’s Talking: Dirk Hofschire, president of market analysis at Fidelity

The Gist: The economic recovery may be weak in its early stages but still stronger than many economists are predicting.

The recession is, or nearly is, over, says Hofschire. But the question now is how strong and sustainable the recovery will be. There’s a growing chorus of skeptics predicting that growth will be tepid at best in the near term, Hofschire says. But historically, steep economic contractions tend to give way to sharp recoveries.

The four severe recessions since World War II (of 2.5% contraction or more) were followed by two quarters of sharp economic growth, says Hofschire. Even in the worst of these cases, the Great Depression, the economy contracted by more than 26% from peak to trough but was followed by 10.8% growth in the first year of recovery, he says.

On the other hand, milder recessions usually precede more modest early recoveries, Hofschire says. For instance, following the last two recessions, 1990-91 and 2001, (the mildest economic contractions on record), economic growth averaged around 2% during the first two quarters of recovery and 2.5% in the first year. Why? Simple math, says Hofschire. Bigger recessions “leave an economy further below its full-capacity potential,” he says, which allows for more rapid growth to return the economy to that former level. Smaller contractions don’t require the same growth to get back to full capacity, he says.

Many people are underestimating the potential for stronger economic growth in the short-term, says Hofschire. Economists surveyed by the Wall Street Journal expect an average growth rate of 2.3% over the next two quarters and 2.4% over the next year, he says. But historically, those growth rates look more like the pace of recovery that has followed mild recessions. What’s being predicted – an extremely severe contraction followed by a mild early-stage recovery -- “has not happened in the U.S. in modern history,” he says.

Meanwhile, says Hofschire, leading economic indicators are looking up. Businesses also posted better-than-expected earnings in the second quarter because they cut costs so dramatically in early 2009, and governments around the world are still providing stimulus and low interest rates to support growth. Granted, Hofschire says there is good reason to be cautious about the pace of recovery in the medium-term. U.S. consumer spending still makes up two-thirds of the economy, he says, and the U.S. consumer, having lost one-fifth of their net worth in the downturn, is borrowing less and saving more. The high level of unemployment doesn’t help either, he says. And economic downturns resulting from financial crises tend to take longer to recover than other types of recessions, he says. Finally, there’s legitimate concern about whether the government will be able to time its monetary and fiscal policies well enough to keep the economy on track after the stimulus ends.

But for investors, all the low expectations could be a good thing, says Hofschire, since it’s the unexpected that tends to move the market. If better-than-expected economic data surprise the market in months to come, it could create “positive ripple effects,” helping to fuel a more sustainable recovery.

Who’s Talking: Alan Skrainka, chief market strategist at Edward Jones

The Gist: Investors should act on all the signs pointing to an economic recovery, especially since the market historically performs well in the first year of recovery.

Skrainka says there are numerous indicators that the economy is on the mend (bank lending increasing, global economies improving, manufacturing rebounding and housing bottoming, to name a few). Given all the good signs, he says, it’s time that investors “start looking forward and stop looking back.” But many investors are hung up on the fact that the official “scorekeeper” of recessions, the National Bureau of Economic Research (NBER), hasn’t officially “called” the recession’s end yet, he says. That’s because “these folks aren’t terribly interested in forecasting turns in the economy,” says Skrainka. The NBER tries first and foremost to make sure that its recession start and end dates are “absolutely accurate and not subject to future revisions,” he says. In fact, the head of NBER’s Business Cycle Dating Committee, Robert Hall, has said it’s more important for the organization to call the end of the recession once economic growth has surpassed its previous peak, an event that could take more than 18 months to pinpoint, according to Hall. In the last recession, Skrainka says, the NBER took 20 months after the recession ended, long after stock prices had started climbing, to declare that it was over.

Skrainka says investors who wait that long to jump back into the market will be missing out on serious gains. Historically, he says, the stock market has performed well in the six months and 12 months following the postwar recessions, an average of 9.6% in the first six months and 15.5% in the first 12 months. Of course, there is still risk involved, he says. The recovery could be rocky and something “unforeseen might derail the progress we’ve made,” says Skrainka. But that doesn’t change his investing advice: Investment decisions should be based on principles (good quality and diversification), not predictions. And remember, says Skrainka, “you can’t recover if you’re not invested.”