The 4 Stages of a Market Recovery

Talk about mixed messages. Stocks are blasting off, yet unemployment remains stubbornly high. The economy grew in the third quarter—posting the first increase in a year—so why all the gloomy talk? And exactly where are we in the current economic cycle? Jason Pride, director of research at Haverford Investments, believes we've entered a period of "true growth," when the economy begins catching up with the market. According to Pride, this is stage three of four in a market recovery. Here's his rundown of each stage.

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1. Extreme Sell-Off. Call it the panic phase. Buyers disappear in the market, and spooked investors start selling. "This selling pushes the market down further, hitting more investors' pain thresholds and leading to even more selling," Pride says. "This self-reinforcing cycle causes a downward spiral in the market where the decline actually accelerates on the way down." Consumers begin to delay big purchases, and companies start to lose confidence, reflected by cautious commentary and a more conservative outlook for their businesses, he says. They also start putting off inventory purchases, and perhaps they don't hire workers that they would normally hire, Pride adds. "The economy and the market are doing things at the same time," Pride continues. "Normally, the market and economy even accelerate a bit into the downturn, and at some point, stage two occurs."

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2. From Burn to Turn. At this point, the market and economy look so bad that it doesn't take much to see improvement, says Pride. "Valuations drop to absurd levels for a number of stocks. Buyers start coming in, and people start to nibble." Pride believes this stage began in March, when stocks hit bottom and were trading around nine times normalized earnings (roughly half of the historical norm). "At this point, some investors' eyes open," he says. Companies start sounding more upbeat, as they've set the bar so low for earnings estimates that even a small dose of positive news allows them to beat expectations, according to Pride. "Those initial achievements come primarily from cost-cutting measures . . . and that starts getting investors' attention. The market starts to move off of that bottom, and you start seeing companies beating estimates. You start to see early signs of life," he says. "Remember, between March and July, people started commenting that things look 'less bad.' "

3. True Growth. This is the stage Pride believes we're in now: "We've seen slight improvements in housing, and initial jobless claims start turning. We've seen companies actually beating on the top line and not just the bottom line." Other signs: The economy begins to post growth, along with some international economies. "Everything is not completely back to normal, but the path back to a more normal economic environment is becoming more visible," he says. "Early indicators of employment—initial jobless claims—begin to improve, but unemployment is still rising and has not started to decline yet." Pride expects this stage to continue up to around the end of the year.

4. Sustained Economic Growth. "Here's where real, sustainable economic growth comes in," Pride says. "Top-line growth and overall GDP growth, having set in for a number of quarters, actually leads to job growth." Then comes inflation. "Everyone is worried about inflation now, worried that we're not going to see employment turning, but these indicators tend to be very lagging in nature. By the time inflation turns up, the economy will be in better shape, employment will be improving, and the Federal Reserve will have greater flexibility to contain inflation going forward without choking off a nascent economic recovery." But don't expect this growth period to mirror past recoveries. Pride believes it's likely to be subpar because of two factors: "First, the government did a lot to stimulate the economy, and there's a payback for this. The stimulus that was used to save us from a more dire economic scenario will have to be removed, and the deficits incurred will have to ultimately be reduced. The act of removing the stimulus and paying back these debts will restrain future economic growth," he says. "Second, the consumer remains overleveraged and needs to get their personal balance sheet back in order. This can only be done through higher savings, at the cost of their spending and the economic activity that results from it."

Even though growth will be somewhat muted, Pride says, "we don't think that means it's going to be a really bad economy, but it's not going to allow us to operate at 3.5 percent to 4 percent GDP growth . . . maybe more in the 2 percent range."