3 things to count on in a recovery

The evidence keeps piling up that the U.S. economy has reached bottom and that a recovery of some sort is in the cards for the second half of this year.

But that’s where the consensus ends. The shape of any recovery remains a matter of heated debate on Wall Street.

As my colleague Don Lee notes in his front-page story today, the “robust recovery” camp was buoyed Friday by the government’s data on second-quarter gross domestic product.

Although the report estimated that the economy contracted at a 1% annualized rate in the quarter -- less severe than the 1.5% drop that analysts generally had expected -- the government also revised previous GDP data lower.


The end result is that the recession that began in late 2007 has been worse than the initial estimates indicated.

That, however, raises the possibility of a V-shaped rebound, because deep recessions typically have been followed by fast comebacks.

But as everyone knows, the backdrop for this recession has been anything but typical. The credit-market meltdown and crumbled real estate prices have financially ruined or crippled millions of Americans and an untold number of businesses, large and small.

The expectation of sustained aftereffects from those shocks has left many economic forecasters doubtful that a V-shaped recovery is possible. Most have taken up residence in one of three other camps named for the letters that describe the pattern that economic growth (or the lack of it) could take: U, L or W, the latter indicating a bet that any near-term recovery would be quickly followed by another recession in 2010.


If you’re trying to make investment decisions based on the assumption that some kind of recovery is imminent, there are at least three things you can count on in your planning, regardless of the letter camp you’re in:

* The Federal Reserve will not be raising short-term interest rates any time soon from their near-zero levels. Even if the economy shows surprising strength in the second half, the central bank simply can’t take the chance of causing an immediate relapse by tightening credit.

If the Fed was slow to raise rates after the 2001 recession -- and it was -- imagine the pressure on policymakers this time around, with the banking system still in a state of shock from the credit-market crash.

That means investors who have trillions of dollars sitting in money market funds and bank accounts can count on earning virtually nothing on that savings well into 2010.

That prospect, if accompanied by even a modest upturn in the economy, could siphon more of that cash into stocks, corporate and municipal bonds and other assets -- which is exactly what the Fed wants, to signal a return to some semblance of normality.

* The “failure rate” in the economy will continue to rise. At the same time, survivors will become more apparent. These are two sides to the same story, which is the radical change forced on the economy by the recession and the credit crunch.

Even if recovery signs continue to proliferate, business bankruptcies are poised to rise as many firms remain shut out from the credit they need to keep going. Standard & Poor’s calculates that 9.2% of outstanding corporate junk bonds have fallen into default over the last 12 months. The firm projects that the annualized default rate will soar to 14.3% by March.

In the housing market the peak of foreclosures is somewhere on the far horizon, as many people who’ve lost their jobs in the last six months soon will find themselves unable to make their mortgage payments -- adding to the millions already in that boat.


And as more businesses and individuals run out of money to pay their debts, bank insolvencies will mount.

Tragic as all of these failures are, they will mean new opportunities for the recession’s survivors. Even if the economy grows slowly, at best, for years, companies that pick up market share from failed rivals can boost their sales and earnings.

If the economy is turning, Wall Street’s hunt for the best-positioned survivors is likely to accelerate, underpinning the stock market. It would only be unusual if investors didn’t respond in this way.

* Portfolio diversification will work to damp your risk of serious loss. Diversification was a bust last year, but history shouldn’t repeat if the economy has bottomed -- and maybe even if it hasn’t.

When the financial system began to fly apart last fall, investors fled virtually every kind of risky asset en masse. People who thought that holding foreign stocks, corporate bonds or commodities would buffer them against a U.S. market dive found, instead, that all of those asset classes plunged in unison.

That was largely a function of the shutdown of credit as hedge funds and other big investors were forced to liquidate investments across the spectrum, without regard to the assets’ long-term appeal, to pay off loans they had used to finance their bets.

With the financial system now stabilized thanks to massive government intervention, the chance of a repeat of last year’s pan-market crash seems low -- even though surprise shocks to the system undoubtedly loom. For one thing, many investors already have significantly lowered the risk in their portfolios by raising cash reserves or reducing debt.

The point is, a large number of individuals and institutions are in a better position now to be discerning about what they want to hold in their portfolios and what they would like to add if opportunities arise from market declines.


And if, like many investors, you’ve boosted your holdings of high-quality corporate or municipal bonds, government bonds or cash this year, you should feel more confident that those assets will do what they’re supposed to do: provide ballast for your portfolio when the stock market inevitably hits more turbulence.