The stock market, will not recover until 2011

Researchers say economic downturn may be longer than historical stock market averages suggest

by Gail MarksJarvis

Are you too optimistic or pessimistic about the economy and stock market?

If you've been encouraged by historical averages, which show the stock market rebounds after 18 months in a bear market, you might be among the people expecting a powerful and lasting surge in stocks later this year. But if you happen to be aware of a piece of research that's making the rounds in the investing profession's inner circles lately, you probably have cast aside the averages and are focused on a much grimmer picture.

Many investors are being told by market pundits and financial planners that relief may be at hand, but this new research suggests that investors who indulge in stocks now may have to be patient for longer than they assume.

"Our view is that the market doesn't recover for another two years," said Kenneth Rogoff, a Harvard economics professor and one of the authors of the research. Rogoff and Carmen Reinhart, a professor of public policy and economics at the University of Maryland, have examined financial crises throughout the world since World War II and concluded that housing, like the stock market, will not recover until 2011.

Financial crises are more severe than typical recessions, the authors said, because the financial system is the lifeblood of an economy. And the longer it fails to pump money into the system, the more the economy is damaged.

In the average financial crisis, housing declines 35 percent and doesn't recover for six years, the researchers found. The stock market, on average, declines nearly 56 percent and the downturn lasts 3.4 years.

Currently housing—measured by the Case-Shiller index—is down about 25 percent after reaching a peak in 2006. And the Standard & Poor's 500 stock index dropped 52 percent from its October 2007 high to its lowest point in November 2008. But the researchers said the severity of the current financial situation makes them think that relief remains distant.
Rogoff said that if the government does not quickly put some of the nation's largest financial institutions into a form of receivership—or short-term national control—the current situation could evolve into a crisis like Japan's or the Great Depression, with the economy rolling in and out of recession for years. Japan began a downturn in the early 1990s and has yet to recover.
A key to fixing the system when widespread banking issues are involved is to take decisive action quickly, the researchers found.

Even with that sort of action, they do not expect growth to return to typical levels for about three years.

"This is among the most serious crises," Reinhart said. "It has hit every strata of finance—the largest banks, the regional banks, and the brokerage industry as we've known it has ceased to exist. This is not like the savings and loan [failures of a generation ago], which were confined to one industry. And this is international to boot."

When a financial crisis is centered in merely one country or region of the world, other, stronger nations help with debt problems and import the distressed countries' products so the economy can strengthen. That was the case, for example, in the Asian crisis of 1997-98.
But in the current situation, financial problems reach outside the U.S. and the world economy is slowing along with ours, disrupting the ability of other nations to help the U.S. by importing products, Reinhart said.

The financial system is so deeply injured, Rogoff said, "I can't imagine robust growth when this is over."

The bailout that will be required is likely to cost the U.S. $2 trillion to $3 trillion, he said. But his research shows that the longer the government waits, the worse the economy will deteriorate and the higher the price tag.

His research shows that it is not the bailout that adds the most cost to governments in a financial crisis. It's the impact of a downward-spiraling economy.

As people lose jobs and business weakens, tax receipts fall. In the typical financial crisis, unemployment climbs 7 percentage points above where it had been before the downturn. In this case, that would put the rate above 11 percent, much higher than the current 7.6 percent.
Unemployment tends to continue to rise even while the economy is starting to stabilize and the stock market is climbing.

Despite their predictions, Reinhart and Rogoff think that with quick action, the recession will technically end late this year.

But Reinhart said the government "must bite the bullet."
To stabilize the financial system, the professors suggest the government take over banks that are insolvent on a short-term basis and then eventually sell assets to private businesses. Rogoff does not think it's possible to cure the problem with private investment initially.