Freaky Like the Long Island Express...

Unexpected events spook markets from time to time—freaky stuff like the New England Hurricane of 1938. Otherwise known as the Long Island Express, the Category 5 storm was one of only three major hurricanes to hit the Northeast in almost 400 years—a rare and destructive event to be sure. But it takes something of wider reach and deeper destruction, like world war, to derail fresh bull markets and deliver a dreaded L-shaped recovery.

Just what is an L-shaped recovery? Being the imaginative creatures we are, humans love perusing economic charts for patterns. In the case of stock market recoveries we find the letters V, W, and L. Other comparisons abound in the press: X, Z, WWW. Heck, Nike CEO Mark Parker called for a Swoosh-shaped recovery in a 2009 conference call. But let's keep it simple here. A V-shaped recovery is the outcome everyone hopes for—a big fall and equally dramatic bounce. W-shaped recoveries bottom, give false hope with a temporary rebound, retest the depths, then recover more decidedly. (Viewed over longer periods, even most Ws resolve into Vs.)

But the intolerable L hits the basement floor, bounces, then…stagnates. Luckily, they're quite rare. To get an L, you need a V-shaped recovery stunted by a largely unexpected, momentous chain of events. The last significant L-shaped recovery occurred in the late 1930s, just as the decade's second major bear market fell -55%, bottomed, and rebounded a quick +62% in 1938. Stocks needed +120% off the bottom to recoup their losses, but new highs weren't in the cards just yet. The nascent revival was cut short by the gathering storm clouds of World War II.

By 1938, Europe boasted a distinctive class of leaders—aggressive, violent, and autocratic. Spain had Franco; Italy, Mussolini; Russia, Stalin; and Germany, Hitler. There was a smattering of hostility mid-decade, but it was German aggression that signaled widespread conflict was unavoidable. The Germans absorbed Austria and annexed the Czech Sudetenland in 1938, completing the conquest of Czechoslovakia the following year. As war worries intensified, uncertainty and fear stopped the budding market recovery in its tracks. No calamity seemed too great or improbable. When else could Orson Welles' radio-adapted War of the Worlds have caused wholesale panic in thousands of households nationwide? Forget World War II. Interplanetary conflict loomed.  

German belligerence continued in 1939. Hitler invaded Poland and bought time on the eastern front by signing a non-aggression pact with Russia. The British and French declared war on Germany that September—but it was too late. Norway, Denmark, Belgium, Luxembourg, and Holland fell in the front half of 1940. That summer, German panzers brushed the British out of continental Europe and rolled into Paris. With Western Europe under its thumb, Germany looked east, invading Russia in 1941.  

The war in Europe was officially raging, but that knowledge alone wasn't enough to cure stocks' uncertainty. A few other questions awaited answers. Would America fight another war in Europe? If so, would it be in time? If not, how much more economic devastation lay in store? On December 7, 1941, the Japanese attack on Pearl Harbor abruptly ended speculation. America would go to war—and as soon as possible. Investor uncertainty vaporized, and stocks began rising that spring. A new bull was brewing.  

What similarly broad event might cause an L-shaped recovery today? The European Union disintegrating would be one possible yet highly unlikely scenario. And that's just the point. Events with such wide-reaching consequences are rare. You can assume the sky is falling every day, but you'll only be right once in a blue moon. So when managing your portfolio, keep an eye skyward (of course!), but favor the road at your feet.