“Phew, I’m glad that’s over!”

Often the payback for a rotten economy/market is the much-needed recovery. Like the respite after a grueling workout, investors can quickly forget the pain with a healthy portfolio gain. Considering that the S&P 500 fell 9.9% in the first quarter of this year, the worst initial three months of any calendar year since 2001, many are hopeful that April’s rebound from the March lows is the beginning of the “Phew, I’m glad that’s over” period.

You may remember this feeling from the last time we were in a similar, though not nearly as bad a place. After three years of losses from 2000-2002, where the S&P 500 fell almost 50%, there was a collective sigh of relief in 2003 when the index rebounded 26.4%. Of course if your portfolio went from $1 million in 2000 to $500K at the end of 2002 and then to $632K at the end of 2003, you still may not be very happy, but investors tended to write off the three years and concentrated on the good year.

So how do the prospects for the coming recovery look? Unfortunately, because of how we got to this place, the “Phew, I’m glad that’s over” period may be weaker than those in the past. The reason can be summed up with one word: leverage, or the degree to which an individual, investor or business utilizes borrowed money. The easiest area to see this is in housing, where homebuyers were able to purchase homes with little or none of their own money, magnifying profits on the way up and eventually, losses on the way down.

In the investment banking world, leverage led to the collapse of Bear Stearns, which had borrowed over $30 dollars for each dollar that was invested. The other major US banks--Lehman Brothers, Morgan Stanley, Merrill Lynch and Goldman Sachs--were not far behind those levels. Compounding the problem, these banks lent to other entities (i.e. hedge funds) that were also leveraged. When borrowed money is financing transactions, it only takes small moves down to wipe you out.

This eventually leads to a cleansing—a de-leveraging period where participants literally pay-down their debts. As anyone who has ever tried to erase a nasty debt knows, the process can be a lengthy one. For that reason, a long period of slower-than-normal recovery may lie ahead. In addition to deleveraging, the Bernanke Fed is likely to raise rates to combat inflation, which will probably accelerate as the disinflationary benefits of globalization recede. That could mean that the “Phew, I’m glad that’s over” period may be when the pain ends, but the upside is not quite as robust.