Just this year, we've seen the S&P 500 lose 30% of its value and then dramatically regain those losses within five months. If you were investing in 2007, that swift climb back to positive performance might strike you as pretty odd. But in truth, the market's behavior since March follows one of the more common recovery patterns.
Stock market and economic recovery patterns are named after letters, which represent the shape the recovery resembles when it's plotted on a trendline. Here is a closer look at five of them and how they might affect you.
V-shaped and W-shaped recoveries
The V-shaped recovery is characterized by a swift rise in share prices after an equally quick decline. As an investor, if you had to pick the recovery type that would follow a crash, you'd opt for the V-shape. It's the fastest and most direct route to restoring the value of your portfolio.
Even so, the V-shaped recovery does have a dark side. The trouble arises when investors rush back in quickly and with too much confidence. If investor enthusiasm outpaces the improvement of underlying factors that prompted the crash, another downturn may result. At that point, the V-shaped recovery ends up being a W. And W-shaped recoveries, characterized by extreme volatility, are very unsettling for investors.
You can see some of these V-type dynamics playing out now, in 2020. When you look at the broad market indexes, the recovery that followed the coronavirus-fueled sell-off in March has a V-shape. But some analysts are concerned about the speed of the recovery. That concern is rooted in the fear that this V could turn into a W.
A U-shaped recovery involves a steep drop, followed by a stagnant period that might last for several quarters before the market returns to growth. In the second half of the 1970s, the stock market demonstrated a U-shaped recovery as the country struggled to work through the pressures of high unemployment and inflation.
Note that the economy and the stock market can show different patterns of recovery at the same time. For example, some analysts believe the U.S. economy in 2020 is tracking for a U-shaped recovery post-coronavirus, even while the stock market follows the V pattern. This demonstrates the tendency for investors to trade based on their outlook for the economy, rather than actual, current economic data.
The L-shaped recovery is probably the last thing you want to see as an investor. It involves a steep decline, followed by very slow growth for an extended period of time. You could characterize the market's behavior around the Great Recession as an L-shape. Share prices faltered in late 2007, eventually hitting a bottom in 2009. The S&P 500 index didn't return to its 2007 highs until the second half of 2013 -- roughly five years later.
No doubt you're wondering how a recovery could possibly show a trendline shaped like a K. The K-shaped recovery is a fairly new label, and the pattern is characterized by different recovery paths for different sectors or segments.
Some pundits are describing the 2020 economic recovery as a K-shape. On one hand, high wage earners who've transitioned to remote work roles are, as a group, managing fairly well through the pandemic economy. But service workers whose jobs rely on foot traffic continue to struggle with high unemployment.
You can see signs of this behavior in the stock market, too. While the major market indexes do currently show a V-shaped recovery, those indexes are propped up by a handful of technology companies that benefit from a mass transition to remote work -- namely, Alphabet, Amazon, and Apple. But companies in other industries like travel and energy have not bounced back at all. As of the end of September, for example, Southwest Airlines is down about 30% for the year, while ExxonMobil is down roughly 50%.
Surviving all styles of recovery
While the market is showing signs of a V- and a K-shaped recovery, it's too early to tell how the future will play out. Given that uncertainty, which is always a factor in investing, you can best protect yourself by sticking to your long-term financial plan. Make sure you have enough liquidity on hand to meet your cash needs for the next five years and, if you can afford it, keep investing consistently each month. Choose stable companies and reliable dividend payers that you can hold through tough times. If share prices rise, you'll benefit with a higher portfolio value. And if share prices fall, you'll lower your cost basis and be well-positioned for the next round of recovery gains.