Many are describing the recovery as V, W, L, or even Q-shaped—the economic recovery that is.
Whatever "shape" the economic rebound takes, the stock market can still rise sharply from here.
Stocks and the economy don't move in lockstep—stocks typically price in expectations of future recovery before signs of economic improvement are evident.
New bull markets climb a wall of worry on the way up, but they don't rise in a straight line.
Remember when alphabet soup was something soothing your mom made when you were flu-ridden on a winter's day? Made you feel better and you learned to spell, all in one go!
Well, leave it to "experts" to ruin the soothing and educational qualities in our favorite soup by describing the coming recovery as V-, W-, L-, or even Q-shaped—sounds stressfully scary, right? But what recovery are these so-called experts referring to? In most cases, it's not the stock market, but the economy. This is an important distinction for investors since the "shape" the economic recovery takes doesn't matter much to stock prices.
Contrary to popular belief, the stock market and the economy don't move in lockstep. Markets typically price in the expectations of future recovery well before the signs of economic improvement are evident. Markets can recover in a V—even while the economy L's, W's, or Q's for a bit.
Stocks lead the economy for good reason. In an economic contraction, firms' revenues take a hit, as do earnings. Since many companies can't immediately adjust their expenses, their bottom lines suffer. They then cut costs, becoming leaner and more productive. The result? Improved earnings—even if revenues remain weak (as we've seen in Q2 earnings reports). Eventually, improved profitability causes companies to spend and hire again, spurring economic growth. This is exactly what we're seeing now. Investors see this happening beforehand and bid up stock prices.
Indeed, the strong stock market rally of the last few months hasn't been accompanied by stellar economic news, but investors have cheered the fact even weak economic data has often exceeded exceptionally dour expectations. This is true for the overall market and for individual categories of stocks as well.
Take Emerging Markets stocks for example. Emerging Markets stocks suffered more than developed markets during the tail end of the downturn only to bounce most when the market reversed course. The same is true for Materials stocks, Consumer Discretionary stocks, and other categories punished leading into the bottom of the bear—the worst during the drop have become the best during the rebound. This is how new bull markets usually unfold. And the longer this current stock market rally continues, the more likely this is the beginning of a new bull and not a bear market rally as some fear.
Some, however, are concerned the recent slight pullback in stock prices means markets are signaling the economic recovery will not be robust or, worse, stagnate. This is likely false. Remember: New bull markets climb a wall of worry on the way up, but they don't rise in a straight line. Pullbacks are just part of the normal, heightened volatility of new bull markets. Let economists have the rest of the alphabet soup, but save the V for investors.