A roadmap to the future?
The latest study from Reinhart & Rogoff, whose paper was presented at the recently concluded American Economic Association shindig in San Francisco, sheds some light on the future based on past events. They studied banking related downturns in the pre-World War II era, as well as a couple of pre-war episodes for which they had data. Their main conclusions are:
First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years.
Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.
Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.
These conclusions aren’t all that different from the IMF study published earlier. Both agreed that financial related economic downturns tend to be deeper and more severe. The IMF study indicated that average recession length of 8.4 quarters (see Table 4.2 on page 9), whereas the Reinhart & Rogoff study showed an average of 1.9 years.
Where are we now?
If history is any guide, given that the U.S. recession began in early 2008, then on average the recession will end in late 2009/early 2010. Reinhart & Rogoff showed that equity prices had an average decline of 55% and the S&P 500 has neared that mark on a peak to trough basis.
This environment suggests that equity markets are in a bottoming, base-building process. We should be prepared for a test or even small breakdown from the lows seen late last year, but the downside is limited. If the average recession ends in late 2009/early 2010, then the timing of the final bottom should occur sometime in 2Q or 3Q 2009.
This analysis seems right to me at a gut level. Equity valuations are relatively attractive. Long term sentiment is washed out. The sentiment level is similar to the first half of 1982, when every day the market saw another piece of bad economic news and the market seemed to suffer the Chinese water torture treatment of declining daily, until no one wanted to hear about the stock market.
Under these circumstances, investors with long-term horizons could start raising their equity allocations now, on a dollar-average basis. Traders have to be mentally prepared for the grind ahead and the opportunities that come with the final bottom this year.