Optimism and pessimism have no place in investing. Let’s look at the economy from a realistic perspective to see why this recession will be nothing like the Great Depression.

The Consumer Who Spent Too Much

Let’s face it: The United States has a consumer-driven economy. Some will have you believe that this is exactly why we are headed for a depression. “You can’t rely on the consumer! It’s fake growth! You have to manufacture! You have to produce!”

In theory, that makes a lot of sense. How long can an economy prosper, if at all, if it primarily relies on consumers and consumer spending?

If we are to believe that an economy can’t rely primarily on consumers and consumer spending, the entire US economy’s growth has been a sham. Not just recent growth, but the majority of growth for the past seventy years.

See, since 1929 (the earliest GDP data available at the BEA), consumer spending has made up 65.8% of GDP, on average. That is, we have always been a consumer-driven economy.

Over the past two decades, the problem with the US consumer is that (s)he started spending a bit too much. Ours is not a country of debt-laden, useless, broke slobs. In fact, by merely saving an extra 8% to 10% of her paycheck, Jane American can be financially stronger than she’s ever been in the past (save the 1940s World War II era).

Her portfolio may be in shambles. Still, no matter how bad things seem, it’s never too late to make some intelligent decisions and get back on track.

In doing so, Jane is not “destroying” America or putting the economy into a downward spiral. (Think of how the media rejoiced yesterday when the consumer surprised the market with spending.)

“Impossible!” naysayers scream. “Unemployment is 8.1% and rising!”

Right, which means that employment is 91.9% which means that 91.9% of our consumer-driven economy can start saving more. And if unemployment rises to 15%, then 85% of Americans can focus on spending a little less and saving a little more.

It’s Happening Now

In the fourth quarter of 2008, personal saving exploded – from 0.4% a year earlier to 3.2%, a hell of a jump in just one year. In fact, at no other point in the past fifty years have Americans increased their savings as a percentage of disposable income as quickly as they have in the past year.

In addition, nonmortgage interest payments started plummeting, down 13% from a year earlier. In the past fifty years, the amount of nonmortgage interest paid by consumers has never dropped so quickly. In fact, from 1948 to 1987 – pretty damn good years in this country- this number never fell.

This has little to do with low interest rates. We know that credit card companies have dramatically increased rates over the past two years. So…people are saving more and paying off debt.

And these numbers are skewed as the savings rate is even greater. Clearly (and sadly) the unemployed can not save; so, they don’t contribute to the top line figures (gross wages), and they detract from the bottom line figures (the unemployed are generally not net savers while they are unemployed).

If you look beyond the numbers, 91.9% of American consumers have, in the aggregate, been paying off debt and saving more and more in recent months. The American consumer spent $240 billion less last quarter than in the previous quarter.

(This, in turn, helps bank balance sheets as well which ultimately helps get us out of the crisis. As consumers save and get healthier, banks also get healthier.)

Forget GDP for a second. It’s dropping. It will continue to drop for a while. The key to a healthy consumer-based economy is not higher GDP – that can be accomplished through nothing more than inflation, if needed. The real key to a healthy consumer-based economy is, well, a healthy consumer.

But We Don’t Manufacture Anything! Trade Deficits!

I know it’s easy to think that. Many of us, especially those of us that are online, reading investment websites, are in cities working service jobs. We also know that the US is a net importer – we’ve been running a trade deficit for years. Some people attribute that deficit to a lack of manufacturing in this county; others say that it’s due to our insatiable demand for foreign goods.

Is manufacturing and production dead in this country? Hardly. In 1929, for each citizen in the United States, we exported about $44 in goods and services. By 2008, that number had grown to more than $4,200 per person. As a percentage of GDP, exports have grown from about 4% in the 1930s to more than 7% in the 2000s.

Both per person and as a percentage of GDP, we manufacture and export more in this country than at any other time in the past seventy years. (Want to fix the trade deficit? I’m not one for “protectionism;” but, if we all just chose to spend $98 per month more on American than foreign goods, our trade deficit is gone.)

In fact, after taking into account inflation, we now produce and export fifteen times more than we did in 1950. Do we produce stuff in this country? More and more each year. So, before we jump to the conclusion that we have no manufacturing outflows from this country, or that the US is a black hole, sucking down foreign goods and services and giving nothing back to the world, consider this: As a percentage of GDP, the amount of goods we exported and the amount of services we exported in 2007 and 2008 were higher than they have ever been since 1929.

In addition, our trade deficit isn’t impossible to overcome. In fact, ours has been shrinking since its 2006 peak. As it shrinks, GDP and our economy grows as a net trade deficit reduces GDP while a net surplus would add to GDP.

When Businesses Cut Back, Look Out

Over the past seventy years, “private investment” has averaged about 15% of GDP. This isn’t investing in the sense of stocks and bonds; rather, it’s the spending that businesses do on equipment, plants, etc. Business investors call these “capital expenditures.”

In every recession, businesses cut their spending on these items as they anticipate lower revenues which will lead to a strained ability to generate cash. The chart below shows Private Investment as a percentage of GDP since 1950, with the grey areas being periods of recession.

To preserve cash, these businesses also lay off workers. In essence, they shrink in real terms…for a while.

To quote Buffett on deferring capital expenditures:

…though dentists correctly claim that if you ignore your teeth they’ll go away, the same is not true for [capital expenditures].

Eventually, these businesses will have to repair or replace equipment, and otherwise ramp up spending. That doesn’t happen, of course, until we’ve swung from “panic and fear” to “I’m glad that’s over.”

In every economy, businesses, in the aggregate, swing like a pendulum – hiring and spending when times are good, and firing and preserving cash when times are bad. In addition to business spending, part of this “private investment” component to GDP is residential spending – spending by households on, well, houses.

If we take residential spending out of the picture for a second, here’s a chart of “private investment” as a percentage of GDP.

Remove Real Estate? But It Is Real Estate, Stupid!

Real estate spending has slowed. Then again, residential real estate spending falls in every recession, and even a few times when we’re not in a recession. Here’s the chart:

We know that foreclosures are still rising; but, let’s think logically about this for a second: In the mid-2000s, we had rampant real estate speculation. People had two, three, four homes/condos. Everyone with a pickup truck was a “developer,” their mothers were real estate agents, and their fathers were mortgage brokers. (Just like when everyone was a day-trader in the late 1990s and early 2000s.)

When home prices started falling, the first to get hit were the speculators. A mechanic with four condos waiting to be flipped was in no better position if he only held three; so, speculators like this had no choice but to flood the market with inventory – being foreclosed on two, three, four properties at a time. Other careless speculators would also walk away from their “investments” as soon as they knew they couldn’t flip them for a profit.

In that sort of environment, we would expect foreclosures to surge initially, especially in the “hottest” real estate markets – places like Nevada, California, Arizona, and Florida. It should come as no surprise, then, that these states have the highest foreclosure rates.

Making up just 21% of this country’s population, these four states have 53% of the country’s foreclosures. Though rising unemployment will add to these figures, the overwhelming majority of gainfully employed people will not walk away from their homes simply because others have. And, while the media focuses on the people struggling to modify their mortgages on underwater homes, let’s keep in mind the tens of millions of people that didn’t buy homes in 2005 through 2007.

(People are using scare tactics as though everyone in this country, or even the majority of people, bought overpriced homes in 2006, are now underwater, and will soon leave the banks to foot the bill on every mortgage they hold.)

Because of that, even though we’re seeing rising unemployment, foreclosures in these four states rose 46% over the past year while foreclosures in the remaining 46 states fell, in the aggregate, by 2%.

(These statistics reflect foreclosure filings, default notices, auction sale notices, and bank repossessions.)

Then Versus Now

You can’t compare today to the Great Depression. In 1930, GDP fell 12%. By the end of 1933, GDP had fallen more than 45% from its 1929 levels, and unemployment was wildly out of control.

What changed in 1933 and 1934 that would turn the economy around?

I hate to say it…Government Spending.

Gasp. Government Spending.

The fourth component of GDP (after consumer spending, private investment, and net imports/exports) is government spending. The government is not a stimulative factor to the economy; rather, it is an employer and spender of last resort. When businesses are firing and cutting back on private investment, the government typically ramps up its hiring and spending to keep the consumer afloat until businesses can get back on track for growth.

By 1941, prior to World War II, the US economy was already larger and stronger than it was in 1929. Unemployment had fallen to less than 10%, GDP had more than doubled from its 1933 bottom, and businesses, which had previously cut private investment from $16 billion in 1929 to just $1.7 billion in 1933, were back on track spending $18 billion in 1941.

Without World War II, our recovery would have continued to be gradual. From an economic standpoint, World War II put our economic recovery on steroids. The butcher, the baker, and the bread maker sprinted back to the US.

But This Spending Is Different! It’s Too Much!

In 1929, non-defense federal spending was just 0.77% of GDP. During the first three years of the Depression, the government did nothing to help curb the decay, actually paring back spending while Americans were losing jobs. Enter Roosevelt, the New Deal, and deficit government spending. (Roosevelt took the country off the gold standard to fund the recovery. Imagine what the headlines were back then!)

Roosevelt more than quadrupled non-defense federal spending to where it would ultimately become more than 5% of GDP in 1936. In essence, Roosevelt and the US Government filled the void when businesses couldn’t or wouldn’t put people to work. By 1942, unemployment was back below 5%, private investment was back on track, having grown tenfold since the 1932 low, and the consumer was healthy again.

One could argue that today’s proposed spending is too much. I’m not going to speak to the fundamental policy changes they’re proposing; but, I’ll tell you this: When Joe American loses his job and can’t find work, he’ll gladly help the government build the high speed train from New York to LA so that he can put food on his table.

So long as Joe is getting a paycheck, we won’t have a depression.

But Higher Taxes Kill Growth!

So the government is proposing higher taxes, and that stunts economic growth, right? After all, who in their right mind would ever start a business or grow their business if Uncle Sam is taking a bigger piece of the pie?

Yet from its 1933 low to pre-war 1941, the economy grew 125%, roughly 10% per year (faster than China today), while taxes on the “rich” went from 25% in 1929 to 81%, with the lowest bracket going from 0.375% to 10%, all while businesses were being launched, business spending was on the rise, and unemployment was dropping.

Though lower taxes might encourage growth, higher taxes don’t kill growth. They provide critical funding for the spender and employer of last resort at a time when businesses are ratcheting down their spending and work force. (This is not a political or partisan statement, but a matter of history.)

And let’s not forget – our country did pretty darn well and a lot of businesses were started and grew from 1940 through 1986, a time during which the top tax bracket was never below 50% (and sometimes as high as 92%).

I’m not one for higher taxes; but, ours are extremely low compared to the historical average.

The Stock Market, Then and Now

A lot of people look at the stock market as a sign of our economic health, the same way that they view daily stock prices as a sign of a company’s health. A year into the Great Depression, stocks had fallen at a pace similar to what we’ve seen over the past eighteen months. Stock prices, however, are not a sign of the economy.

The 90% stock market plunge of the Great Depression was insane. Then again, from top to bottom, GDP – the US economy – fell 45% from 1929 through 1933. Their market effectively crashed in October; our market started crashing in October. They had a banking crisis; we have a banking crisis. Theirs was global in scope; ours is global in scope.

Those are about the only similarities one can draw.

By this time in the Great Depression, unemployment was nearing 20%. Today it’s 8.1%. First year Depression GDP had fallen 12%; ours grew 3% in the first year of this crisis. Depression-era government did nothing to stop the fall in the first three years; ours is trying to stop the bleeding and to, in time, create jobs to keep the consumer healthy and offset business losses.

I can promise you this: The inflation that follows as a result of today’s actions is certainly better than the hard times of the Depression. Nobody would dare say that the high inflation of the late 1970s and early 1980s was anything like the utter despair of the early 1930s.

Those Toxic Assets & Credit Flow

Let me end with the garbage that started this in the first place: Frozen credit and level 3 “assets.” Let’s start with Buffett on these level 3 derivatives in his 2002 Letter to Shareholders:

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind.

With so many banks, brokers, insurance companies, pensions, and hedge funds tied together in a derivative cesspool, the failure of any one of these large institutions would pose a systematic risk. Lehman failed, and the system froze. (Hence the bailouts, to prevent further problems and “minimize links of any kind.”)

We’re all mad as hell, and rightfully so. Still, it’s not the end of the world.

The economy is shrinking somewhat, but certainly not as fast as the Depression. In addition, we have the backstops in place (government spending) to keep us afloat if businesses continue to contract. Though we’re engaging in deficit spending, we’re issuing bonds at 2%.

At 2%, the government should borrow as much as it can, reinvest it in America at 5% or 6% GDP growth, and thank the world for providing the funding. This is good debt, assuming our leaders don’t waste it all studying pig farts.

People are saving more and paying off debt, which directly strengthens bank balance sheets. Though credit locked up in October of 2008, it has gradually started flowing again (see the TED Spread) which means that businesses and individuals – healthy businesses and individuals – can conduct business or manage their finances.

(The fact that the $18,000-a-year couple still can’t get a $700,000 mortgage like they could two years ago is a good thing.)

The stock market is getting to a point where it is predicting the end of capitalism. Some businesses will go away; some will grow stronger. Be realistic for a second: until the government gets into the soft drink business, Coca-Cola is a pretty safe bet. Of course, most people don’t belong in stocks in the first place.

Is this the end of capitalism and America? If we ignore the facts and listen to the media, it must be. And I fear it will end the same way America ended during the last six depressions:

Early last week, when the headlines noted that the market’s losses had reached the worst levels of any decline since the late- 1930s, some analysts dutifully trotted out new “how low can it go” numbers for the Dow Jones industrial average. Would 6,000 do it? Maybe 5,000? One estimate came in at 777, with a forecast for an accompanying U.S. economic depression. – LA Times, 10/13/2002

No. The nation is in an economic depression. Gramm-Rudman is not going to solve that, and cutting the budget to the bone will only make things worse. We need to return to American System economics, and fast. We need aid from the Asians and Europeans, and the Paris-Berlin-Vienna triangle of industrial production. – Scott Gaulke (D), LA Times, 05/27/1990

Economic depressions may not be a thing of the past, according to some respected economists. The experts cite some striking parallels between 1929 and today, including the overheated stock market, trade imbalances and the rise in protectionism, greater polarization in the distribution of wealth and the prevailing mood of optimism among investors and the general public. – Chicago Tribune, 10/9/1987

Concerned that there’s no relief in sight from high interest rates, many Americans believe the country is now in an economic depression. – Washington Post, 7/26/1982

Depression. It is a word to send shivers down the spine of anyone over 50 years old. It evokes dark images of bread lines and bankruptcies, dust bowls and suicides. It is also a word being used by responsible public figures generally liberals for the first time since the nineteenthirties to describe the state of the nation’s economy. – NY Times, 3/7/1975

Marshall McLuhan, the intellectual comet from Canada who now resides at Fordham University, startled broadcasting executives here today with a forecast that the United States will have an economic depression “within about five years.” – Washington Post, 9/29/1967

A broken clock is still right twice a day. The problem is this: If you look at that clock at that exact “right” moment in time, you should not automatically assume that the clock is always right. Warren Buffett came out recently and said how “dumb” he was in 2008. Should we then assume that Buffett is doomed to be eternally wrong in the future?

The “Credit” Economy

In this March 2nd article on SeekingAlpha, Schiff posits that the government’s plan to restore the flow of credit is somehow a plan to entice people to leverage themselves further to the hilt.

Government efforts to simply make credit available, without rebuilding productive capacity or increasing savings, are doomed to destroy what’s left of our economy.

True. But then he goes on to explain how a “real economy” works in simple terms:

Suppose there is a very small barter-based economy consisting of only three individuals: a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candlesticks and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candlesticks, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.

He continues, explaining what would happen if the candlestick maker began borrowing steaks and bread, issuing IOUs, yada yada, until there was a natural disaster that destroyed all the equipment and nobody could produce anything any more. The takeaway lesson: If everyone maxes out their credit cards and a meteor hits Earth and destroys every business and piece of equipment, our economy might have some problems.

(I’ve got news for you Mr. Schiff: Not everyone is leveraged to the gills.)

Growth in the “Real” World

Let me propose a different scenario to Schiff’s doom and gloom economic outlook. We have the same three players above, but we also have a city down the street with ten unemployed, starving citizens. The butcher employs one of these citizens so that he can work a little less. That citizen, now enjoying a paycheck, buys a candle. With increased demand, the candlestick maker hires a citizen, who in turn starts buying bread.

And so on and so forth until all ten citizens are employed.

Credit in the “Real” World

Everything is hunky dory and the three empires – bread, meat, and wax – are expanding into neighboring cities. Demand is through the roof, and the businesses rapidly expand. To fuel this expansion, the three companies put themselves on “credit” – borrowing from each other in the short-term to finance growth. (Example: The candlestick maker needs the fat from the cows to make candles. He’ll pay for that fat when he sells the candles.)

Short of a Peter Schiff natural disaster that wipes out the machines needed to make the materials, this system works just fine.

Debt in the “Real” World

The citizens, enjoying their newfound wealth, start spending like crazy – some beyond their means. A few citizens start banks; some start clothing shops. A small portion of them – say, 10% or 20% – borrow too much from the banks to buy from the clothing shops.

It’s fine while the system is working; but, along comes a draught. Grains dry up, which puts the baker in a bind. With grass in short supply, cows aren’t as fat; so, meat is scarce. Less meat means less material for candle wax.

Not able to produce as much, the “Big Three” employers lay off workers. Some (though not all) of those workers are overextended on their debt; so, they blow off the bank. The bank begins to lose money; so, they stop lending to everyone else.

Unable to borrow money to purchase threads to make 1,000 shirts, the clothing maker now has to make just 400 shirts.

The economy now hits a critical point, at which a decision must be made. Do we let it “work itself out,” knowing that we will have real pain and shrinkage at all levels until we find balance, at which point we will have flushed the bad debt out of the system? Or, do we help free up credit so that the rest of the system isn’t poisoned by the draught hurting the Big Three?

Finding a Balance

Where Schiff and Roubini have it wrong is in the end result. According to them, everything in the economy is going to zero. We have to reboot the system, which means that we’ll all move out of our homes and into the woods to start picking berries and making stone tools until a new butcher, baker, and candlestick maker come along.

During the Great Depression, we couldn’t possibly lubricate the system because our currency was tied to the gold that the country had in its coffers. It took a World War and the export of 20%+ of our male “consumers” to bring the butcher, baker, and candlestick maker back.

Today, we can manipulate monetary policy to grease the wheels. Admittedly, we won’t see Dow 14,000 for quite some time. Still, without plowing money into the system, the “Greater Depression” would have already been upon us.

People might buy fewer shirts; but, unless you think we’re all going to run around naked, the strongest tailors will survive. If they don’t, another citizen will step up to seize the opportunity and become tomorrow’s employer.

Until we have 100% employment around the world, this is how “real” economies work. We don’t live in a limited citizen, fully-employed, this-for-that economy that is being destroyed by an abundance of credit and a series of natural disasters. The problem lies in the non-productive “assets” – an overabundance of “investments” that were believed by many to be assets, but ended up being liabilities.

Pain Today or Pain Tomorrow?

To correct the situation, we have to grease the wheels. I hate it as much as anyone else, but that doesn’t change the fact that it needs to be done. Few people believe that we can “sit in the tub” while President Obama takes care of things, as Mr. Schiff suggests.

People will need to make sacrifices – greater than they are now. We need to save more – that goes without saying. For example, the few thousand people that read this article will likely do so on a computer, over somewhat expensive high speed internet, with all the lights on in the room. I’d be willing to bet the TV is on in the background while the cell phone sits quietly, racking up those rollover minutes they pay for but never use.

Before you load up on ammunition and bottled water, realize that today’s actions will certainly lead to tomorrow’s stagflation or inflation, but the game isn’t over. Once panic and fear pushes the pendulum beyond the point of equilibrium, things will start to improve.

Now, the race is on. Who will win? Schiff and Roubini, whom have so convinced people that the end is near that nobody will make changes? (Why should I cancel cable or pay off my debt if everything is going to hell?) Or, the desire for a better tomorrow, at the expense of today’s instant gratification? (A vision that a lot of people lost a long time ago.)

Is there more pain ahead? Yes, and probably for a number of years when factoring in the stagflation or inflation that is on the way. Nobody is denying that. Still, to promote a full reboot and going back to a “cash only” society is ridiculous. The problems we face are not due solely to the use of credit; they are due to a massive mispricing of risk at many levels, leveraged by the irresponsible use of credit.

If you want to burn me at the stake, go right ahead. But before you do, consider this: At what point will Roubini and Schiff become bullish on America…on businesses? At what point will they declare that stocks are cheap? If they have their way, you might want to save that match – you’ll need it when the power companies shut down and you’re foraging the Earth for sustenance.

(For the naysayers that want to immediately jump down my throat without reading this article, keep in mind that Roubini and Schiff were not the only ones to see the writing on the walls – they just have great press agents. While they were booking media appearances and kissing babies, some of us were moving clients largely to cash and/or bonds in 2007 and 2008.)

(Inadvertently, some of these little diversions of mine creep into my investing by helping to increase my sphere of competence and confidence in various businesses and industries.)

The other night, while searching for capoeira studios in Chicago (it’s pretty cool, but I doubt it will help with investing), the television caught my attention. CNBC was airing A Year of Fear and Hope, and I started to marvel at how ridiculous 2008 has been.

Let me preface this by saying that I understand how grave the situation is for many people, and I certainly do not intend to make light of the economic woes of people around the world. People have lost their homes…their jobs…their retirement savings.

Still, the reasons behind the events of 2008 have been nothing short of ridiculous. (That’s why I’m conflicted on the bailouts – we need them, but we shouldn’t need them.)

The various personalities on CNBC were talking about how shocked they were – how mind-boggling the situation was – as scandals, failures, and bailouts kept popping up. They were talking about the year’s events and I kept thinking: Oh yeah. I almost forgot about that.

PREDICTING THE MARKETS

Warren Buffett is quoted as saying:

It’s far easier to tell what will happen than when it will happen.

Nobody could have predicted that the Dow would fall 48.2% from its October 11, 2007 high of 14,279.96 to its November 21, 2008 low of 7,392.27 – a level that was first reached on May 27, 1997. (Of course, I’m hesitant to say that the November low was the lowest we saw in 2008 – there are still a few days left in 2008 and we’ve seen plenty of 1,000 point swings!)

Even Buffett himself couldn’t have predicted the when – he started accumulating cash in Berkshire back in 2003, four or five years too early. Few, if any, big money, time-tested business investors tried to predict the when by shorting. Instead, they clung to cash, either because they knew that the chickens would eventually come home to roost, or because their insistence on having a wide margin of safety caused them to find few opportunities.

THAT SAID…

2008 was not entirely unpredictable. Some events – like the collapse of certain financial institutions, the fall of the auto makers, or the drop from near-$150 oil – were highly predictable. The when was unknown; the what was not rocket science.

Take, for example, General Motors. In July, I had put together a report – Owner Earnings vs. Free Cash Flow – in which I discussed how the value had deteriorated over the years and why its business was suffering.

In this case, GM’s automotive business is even uglier than we thought. The company’s operations required nearly $11 billion of cash in 2005 and 2006. In 2007, the business was hammered even worse, requiring nearly $47 billion of excess cash just to keep the cars coming off the assembly line.

How did it cover this shortfall? It began selling businesses, selling finance receivables, playing games with the pension and OPEB, refinancing debt, and working some tax magic…

Price follows value. When the value deteriorates rapidly (as is often the case when a business’ operations are cash-hungry beasts), the stock price is usually not too far behind.

Or, look at the price of oil. In July, it approached $150 a barrel, almost double what it had cost a year earlier. Over the long-term, capital markets work on supply and demand; so, a simple supply-and-demand question would have stopped people from ditching their Hummer for a Prius simply because “oil was going to $200 and gas was going to $10.”

The question: Did the demand for oil double in the past year? I understand that more goes into the question than I’ve put here (eg., the dollar, was oil undersupplied last year). Still, the more likely conclusion was that there was a bubble in oil prices and that it would eventually regress to the norm. (That, of course, speaks to the danger of so many moron managers with so much money – they can push an economy on the brink of collapse simply because they don’t want to be the last one in oil when it hits $150.)

Just don’t tell our secrets to the mutual fund managers that were invested in $147 oil, or in General Motors or other debt-laden, cash-hungry businesses – they’re sleeping.

BEAR STEARNS, LEHMAN, MERRILL LYNCH, WASHINGTON MUTUAL…WHO?

They were some of the biggest players in the world of finance. Well, that’s what I’ll be telling my kids one day. The Are You Kidding Me?!? factor I talked about in this post is waning; still, I am amazed at how stupid these managers can be.

Let’s face it – we’ve all made investing mistakes in the past. Nobody is immune. The question investors need to ask – and it’s the number one question we consider when determining clients’ allocations – is: How would your life change if this particular investment dropped 50%? If a 20% drop in your portfolio is enough to make you sick, you shouldn’t have more than 40% of your portfolio in stocks because, at any given time, your $50 stock can drop to $25, regardless of whether or not the world appears to be going to hell in a hand basket.

In the case of these investment and banking institutions, they didn’t ask the most basic of investment or money management questions. And it didn’t take a 50% drop in their investments. A much smaller drop caused them to go into panic mode because they had already planned for (or spent) the profits they expected to make. Sure, they’ll blame it on the fact that the credit markets froze; but, Wells Fargo, JP Morgan, and US Bank played in the same sandbox, and they’re still here.

Shhh. You’ll wake the mutual fund managers!

ANGELO MOZILO, BERNIE MADOFF…AND EXECUTIVES?

Right now, the Bernie Madoff $50 billion ponzi scheme is front page news (and yes, I’m aware that my last name is Ponzio, not to be confused with “ponzi” schemes. I tried to change my last name to Enroni, but I had problems at the DMV.) In a ponzi scheme, the fund manager sends fake statements to people and, when people want to sell, pays selling investors with the money raised by new investors. Madoff allegedly did this for some thirty years.

If the allegations are true, Madoff joins the ranks of some real pieces of trash on Wall Street – guys like Angelo Mozilo, who cashed out roughly $200 million of Countrywide stock options in 2007 while Countrywide failed, and who was lucky enough to sidestep the spotlight because the financial crisis hit.

That, of course, brings us to another lesson from 2008: Just because you can doesn’t mean you should. I’m not talking about Mozilo or Madoff – they did or allegedly did something you can’t do. I’m talking about corporate executives, like the clowns at Bank of America whom have diluted their shareholders to the point of absurdity. In time, they may make money from purchasing Countrywide (though I think they grossly overvalued the “brand”) and I’m sure they’ll make money from their acquisition of Merrill Lynch if they can restore some of the respect that accompanied Merrill’s name.

But at what cost? Just because you can issue stock to acquire troubled or failing businesses, should you? And if you do make such bonehead moves, should we be surprised that your stock drops 75% while the value of your business – and hence, the value of the stock – plummets?

I’m not saying that Bank of America isn’t cheap – it may very well be. Still, there is no way to know for certain if management is going to continue to dilute shareholders for acquisitions simply because it can. I like the fact that they are looking for blood in the streets; but, not all blood is created equal.

IN 2002, THERE WERE “DEBACLES.” IN 2008, EVERYTHING WAS “UNPRECEDENTED.”

I remember watching CNBC back in 2001 and 2002 – everything was a “debacle.” Today, everything is “unprecedented.” I’m certain that, as Wall Street regains its footing, it will do something stupid again in a few years, and we’ll have a new buzzword on television.

As amazing and volatile as 2008 was, and though many of the debacles were unprecedented, it was not entirely unpredictable. Whether you made or lost money in 2008, the most important thing is that we take the lessons learned and apply them in the future.

We all remember that 1+1=2 – it’s a lesson we learned when we were just a few years old. From here on out, always remember the lessons from 2008:

• price follows value in the long-term. Focus on value; the price will take care of itself. This is true even if Wall Street or the media is throwing the markets in your face.
• never invest in something you don’t understand. Robert Crawford wrote this explanation on how to value financial institutions. Even with his help, I never truly understood financial institution valuation; so, I avoided the slaughter of 2008. Ignorance is bliss – especially when you’re on the sidelines while so many investments and companies crumble.
• losses are real, even if you don’t realize them. Many investors are afraid to sell anything or refocus their portfolio because doing so would “make the losses real.” Bad news: If you overpaid for your investment, the losses are real. Just ask anyone that purchased Cisco Systems early in 2000 as it was approaching $80 a share. These investors overpaid for their stock and are still down 80% or so after eight years.
• losses are not real unless you realize them. Notwithstanding the above, short-term quotational losses are not real if the value of your business (i) is growing and (ii) is greater than the current market price…unless you sell.
• you don’t have to own stocks. Many financial “professionals” will tell you to have 60% in stocks and 40% in bonds, or to subtract your age from 100 (or 120) to determine what percentage of your portfolio should be in stocks. If they took their heads out of their…computers…for a second, they’d realize that stocks and bonds have nearly the same returns over the long-term. In February when I wrote Stocks Stink. Buy Bonds!, the stock portfolio slightly beat the bond portfolio. Today, the all-bond portfolio beats the stock portfolio. And that’s over forty years! If you aren’t going to try and beat the markets, you probably shouldn’t be in the markets.

It’s interesting that, no matter what is going on in the markets or the economy, the fundamentals remain unchanged. Is it a different market? Perhaps, and that will change the way that people gamble on stocks. Intelligent investing hasn’t changed one bit.

SIGNING OFF FOR 2008. HAPPY HOLIDAYS. SEE YOU NEXT YEAR!

I’d like to wish you all a Merry Christmas, Happy Chanukah, Happy Kwanzaa, Buon Natale, Feliz Navidad, Boas Festas, Joyeux Noel, Froehliche Weihnachten, Mele Kalikimaka, Shub Naya Baras, Kala Christouyenna…and Happy New Year to the 4,000,000+ visitors around the world that make F Wall Street so much fun!

Much of it was stolen from Warren Buffett; so, send him your hate mail. (This report will also provide insight into why Buffett held mostly US Treasuries the past few years (until now) in his personal portfolio.)

I won’t try to predict the actual level of the markets five- and ten-years from now; but, it is possible that growth will be very slow (4% to 6%) and it is highly probable that investors looking for long-term growth of 10%, 12%, or 15% in the markets going forward are likely to be very disappointed.

Buffett, on his reasoning that future investor returns of 5% to 7% are more likely than 10% to 15%:

Now, maybe you’d like to argue a different case. Fair enough. But give me your assumptions…The Tinker Bell approach – clap if you believe – just won’t cut it.

As always, this is an attempt to predict the future, which is cloudy at best. Still, I’d rather look through a foggy windshield than drive using only the rear view mirror.

So, with the letter written and ready to go out in the next day or two, I’ll ask you the same question I asked my friends and family before I gave them the letter:

Why do you think the stock market will be higher ten years from now?

(Most common answer: That’s what it does – it goes up over time.)

As you consider this question, don’t look at Friday’s close or speculate about where the Dow will close in 2018. Instead, look at averages. The Dow averaged about 10,500 or 11,000 this year. Why should it be much higher than that ten years from now?

Obviously, I don’t have all the answers and I don’t know where the markets will close tomorrow or in 2018. All I can do is shamelessly steal from Warren Buffett’s past discussions on the subject. (And if you’ve read those, don’t spoil the answer for everyone else!)

Feel free to spark a discussion in the comments, or just give the question and your answer some serious thought. I won’t jump in to the discussion until after the letter goes out.

EDIT: Rene brought up some great points; but, I should have clarified this question. I’m assuming that it’s business as usual in the United States. I’m not talking about making fundamental shifts, though one could argue the necessity of those shifts. I’m asking: If it’s business as usual in the United States, why should the stock market be higher ten years from now?

(It’s somewhat funny because the people that thought they might have heard a big Ooops had clearly missed the long-term outlook of that letter.)

The F Wall Street Portfolio

Clearly, I had to make some changes to the F Wall Street portfolio. Our permanent holdings remain just that – permanent. As for those stocks we intended to dance in and out of – we danced out of some of them. I’ll get to those next week.

Perhaps I should have heeded some of your warnings (René was very outspoken and forward-looking) – I did not expect things to deteriorate so rapidly or so violently. Though the problems in the economy began long ago, they really escalated over the past month. I try to look through the windshield as I’m driving; still, the road looks different to all of us.

All told, the damage to the portfolio is minimal compared to the overall markets. As Tom mentioned in this comment, you shouldn’t follow the F Wall Street portfolio precisely because it is not updated in real time. The strategy and approach doesn’t change; the positions do.

All in all, the F Wall Street portfolio is down a few percent from its start a year and 40% ago. Following Buffett’s strategy, if we can lose less than the markets in a down market, earn money in a flat market, and try to keep up when things are going well, our returns should be quite “satisfactory” and should beat the markets over the course of three and five years.

Taking Action in Today’s Markets

If your investing is done entirely in the rear view mirror (which, by the way, is the inherent danger in relying blindly on automated spreadsheets), it looks rosy out there. If you look through the windshield, the outlook for the markets is mediocre at best.

Tomorrow, I am sending out Part II of the “Investing in the Global Credit Crisis” series. In it, I’ll talk about what really drives the stock markets in the long term. (Hint: It’s not just earnings growth.)

Portfolio Hedging For The Nearly F’ed

Over the past two weeks, I have seen sheer terror and depression in people’s eyes. A lot of people have lost 40%…50% of their savings and net worth. Advisors are screaming, “STAY THE COURSE!” and “WE’RE SETTING UP FOR A BULL RUN!”

I don’t have any special insight into the markets; but, I do know that the conditions are present to create a market that is different from the 1982 to 2000 bull market, and more like the 1965 to 1982 flat market. (More on that in tomorrow’s report.) I am an eternal bull on individual companies and their stocks; but, I wouldn’t want to be broadly diversified across the stock markets for the next five or ten years.

(Mind you: My outlook on the markets is for the long-term, same as my outlook for Johnson & Johnson. All that any of us can do is try to predict the future with a degree of confidence and competence. If you know something beyond that, load up on lottery tickets.)

If, like so many Americans, you are broadly invested (through a lot of stocks and/or diversified mutual funds) and don’t want to sell just because you’ve lost too much (ie. you’re making decisions based on what you see in the rear view mirror), consider hedging your portfolio for against further downside. The ProShares UltraShort S&P500 (SDS) looks to make 200% of the inverse return of the S&P 500. That is, before fees and expenses, if the S&P 500 drops 5%, SDS will make 10%.

To me, this is a great hedge if you can’t bring yourself to sell anything. If the markets (and your portfolio) go up 30%, SDS will lose roughly 60%; but, a 30% gain in 85% of your portfolio, offset by a 60% loss in your 15% SDS position, would leave you up about 16.5%. On the other hand, if the markets fall 30% from here, you’d lose roughly 16.5%.

Mind you – I’m not advocating a “predict tomorrow’s market” strategy; rather, I’m saying this: Considering the amount of uncertainty out there, and if another 20% or more loss would push you from “feeling f’ed” to “totally f’ed,” you should hedge against those potential losses. Remember: You don’t have to make it back the way that you lost it.

Switching The Tone

Many of you have expressed concerns that I’m switching to panic mode or fear. Not true. When it comes to the stock markets, there are three approaches:

• optimism,
• pessimism, and
• realism.

I’m a realist. I feel no emotion in the markets or in my investment decisions. The recent “flight to cash” or “hedge your portfolio” posts and comments are not a fundamental shift from bull to bear, or a sign of I-don’t-know-what-to-do-but-I-have-to-say-something confusion.

To provide a little history here, as it can be lost in the sea of F Wall Street posts:

• I Say: Let Them Crash – August 20, 2007
• When People Are Happy, Protect Your Portfolio – November 12, 2007
• Stocks Stink. Buy Bonds! – February 6, 2008
• How Bad Will This Get? The Recession. – March 19, 2008

And, of course, the posts from this month. Throughout the last year, I got slammed on a number of occasions for being pessimistic. When times are good, warnings of caution seem pessimistic. When times are bad, bulls sound like they’re full of, well, bull.

During that time, I was bullish on individual companies, but bearish on the vast majority of companies and the markets. Since then, a lot has changed in the markets, but nothing has changed in my approach from 18 months ago.

Hopefully, that will become more evident with tomorrow’s letter that will be available on Meridian’s website by late tomorrow (Friday) morning.

It is being sent to our clients today via e-mail (about half have received it), and is now available for download as well. You can download it for free here (no registration required).

Feel free to pass the report or link on.

Here’s what I had said in the e-mail as I sent out the report:

To my friends, family, clients, and others:

Attached is a 9-page report about understanding, saving in, and investing for the global economic crisis. It’s really bad out there right now; and, it’s likely to get much worse before it gets better. If you are having a hard time figuring out what to do right now, this report should help. Excuse the typos, if any. I felt the timeliness and depth of the content was the critical part. As I write this e-mail, the Dow Jones Industrial Average hit a daily low of 7,882.51 – a level first achieved by the Dow on July 21, 1997. In addition to losing nearly 50% over the past year, many people have lost 11 years of saving and investing.

This isn’t your standard “stay the course” strategy that many investment advisors and talking heads are promoting. Instead, this report should help you understand the problems and its implications going forward. Feel free to pass it on to others, or let them know they can download it for free from http://www.meridgroup.com/blog/7.htm.

Now is the time to look for permanent holdings; but, keep a watchful eye on the situation as it unravels.

Let me pull one line out of the report that is of critical importance as you consider your strategy going forward:

[P]ortfolios must be managed in a dynamic way so that they are not reactive to the markets, but carefully planned for the future.

On a broad market and economic scale, the future looks bleak for the next few years; so, forget reacting to what has happened and carefully plan your portfolio for the future, even if that means taking losses now.

This crisis is unlike anything we’ve seen in recent history (and perhaps not-so-recent history); so, what should we do now?

First, Stocks Stink. Consider Buying Bonds.

One year ago (actually, on October 11, 2007) the S&P 500 topped out at 1,576.09. Today, it hit 1,007.97 – a 36% loss. From top to bottom, the Dow lost 32% over the past year. While the news is reporting that we closed at 2004 levels, I think a much more sobering reality needs to be addressed: Over the past ten years – from October 8, 1998 through today’s close – the Dow has grown just 2.6% on average for ten straight years.

Add in dividends, take out some management fees and commissions, and you’re lucky to have a 4% or so return for a decade.

(And I won’t say anything about how irresponsible, foolish, or downright fraudulent some of Wall Street’s finest were over those ten years. Remember Lucent? WorldCom? Enron? Merrill Lynch? Bear Stears? Really – I don’t want to beat a dead horse.)

(Morons.)

What can Joe and Jane American learn from all this volatility? First off, remember that stocks stink! A portfolio of solid bonds would have crushed the stock markets over the past ten years; and, while I don’t necessarily advocate 100% bonds for everyone, I do think that most people should own them.

Wall Street doesn’t talk about bonds except to the extent that they try to get you to buy bonds funds. Individual bonds are not very profitable to Wall Street; bond funds will pay your broker the quarterly kickbacks and allow you to be put on the back burner. (What adviser wants to track all those individual maturities or have to actually do some research?)

That leads me to my first point: Beware of bond funds.

The Danger of Bond Funds

Simply put, when you invest in a bond fund, you give the manager $x to purchase bonds. The manager then takes your cash, pools it with cash from other investors, and buys bonds of varying maturities.

Sounds pretty harmless.

The problem with bond funds is not in the buying, but in the selling. When investors sell their bond funds, the manager must generally sell bonds to pay the investors. The problem is that bond prices change; so, the manager might have to sell some bonds that you personally would have held to maturity.

How does this affect you? Consider this: You want to hold bonds for income and stability; but, in bond funds, your income and stability is directly affected by the actions of other investors. If a ton of people are buying into your bond fund today, your manager will be forced to buy bonds for you in a low interest environment. Then, when those same investors want to get out of that bond fund in five years – and if interest rates are higher – your manager might have to sell those low interest, now low priced bonds at a loss.

At the end of the day, you got a raw deal.

Instead, focus on buying individual bonds with the goal of holding them until maturity. If you buy a high quality bond offering a 5.5% yield until June of 2009, you know exactly what to expect – a 5.5% return for two years, and a definite dollar amount upon maturity, regardless of how happy or scared other investors are.

In short, don’t let the panic and fear of other investors determine your return if your goal is stability, income, and a defined return.

Second, Realize That Volatility Is Here To Stay.

I’ll admit – 6% or 8% daily swings in the markets are out of line. Still, volatility is here to stay. If you recall from this earlier post, the average number of daily transactions in the markets have grown 562% over the past ten years. Every day, 4.4 billion transactions occur, each moving a stock price in a certain direction.

Over the past two weeks, this number has grown to more than 8 billion transactions. If you are waiting for things to calm down, you’ll be waiting a long time. There is simply too much excited money floating around to ever return us to consistently small and “comfortable” movements.

If 36% losses make you sick to your stomach, it’s time for a reality check and a new strategy. Diversification (ie. holding a bunch of investments) is not the key – asset allocation is what will help you sleep at night.

When you are putting money to work in stocks, you must have a completely iron constitution. If watching your portfolio drop 50% will make you nervous, you shouldn’t be 100% invested in stocks. Nobody likes 50% drops and we’d love to avoid them whenever possible; but, if you’re 100% invested and prices drop quickly with no fundamental change in your businesses, you’ll suffer some big temporary losses in your portfolio.

Combating Volatility the Intelligent Way

Many advisors will tell you that “diversification” will help mitigate losses and maximize returns. Then, they sell you a mutual fund that holds hundreds or thousands of stocks.

It doesn’t make sense.

If the key to growing and preserving wealth (as Buffett has said) is putting your money into great investments and great prices, how can it make sense to buy a basket of great, mediocre, and bad companies at great, mediocre, and bad prices?

As of June 30, AllianceBernstein Holding LP; ClearBridge Advisors, a subsidiary of Legg Mason Inc.; Fidelity Management & Research LLC; Barclays PLC unit Barclays Global Investors NA; Wellington Management Co.; and State Street Global Advisors were the mutual-fund managers with the largest stakes in Lehman’s stock, according to FactSet.

So said the Wall Street Journal on September 16, 2008. While most of the funds did not comment, Vanguard’s Rebecca Cohen had this to say:

If you look at the absolute number of shares, we end up as one of the larger holders of Lehman…but on a relative basis, it’s a relatively small portion of our funds.

Oops. We lost hundreds of millions of dollars of your money; but hey, you were diversified. You only lost a little (even though you shouldn’t have lost anything in Lehman).

The intelligent way to combat volatility is to realize how much volatility you can handle, and then invest the rest in bonds. If you take a step back and realize that 50% losses are possible, then you have a base for building your portfolio.

Comfortable with a 10% drop, but not a 15% drop? Invest 20% in stocks and 80% in bonds and cash. Okay with a 25% drop but not a 30% drop? Put half of your money in stocks and half in bonds.

Focus on intelligently allocating your portfolio, not on broadly diversifying into more and more mediocre and bad investments. After all, those broadly diversified, armchair investor stock and index funds are down just as much – if not more – than the markets right now.

Don’t Change a Darn Thing in Your Approach

It is times like these that many investors panic and change their investment strategy in stocks. The fact that the markets are down does not change the fact that:

1. stocks are pieces of businesses with intrinsic values;
2. the value is the amount of cash that can be taken out of the business during its remaining life; and,
3. price follows value, even if it takes a few years for that to occur.

When we bought Johnson & Johnson last year, we looked sheepish, as though JNJ was a boring buy at $62 or so. A few months later, we looked really smart as JNJ topped $72 a share. Today, it was down as much as 14% from its near-$73 high, and many people are kicking themselves thinking, “Boy, I wish I took my profits $10 ago.”

Why did we buy Johnson & Johnson at $62? Because we saw more than $62 – and more than $72 – of value. As the company’s value continues to grow, we have to sit back patiently until Mr. Market is ready to realize it.

It may take a few months; it may be years.

Finally, Realize That It Will Be Better In a Few Years

I wish the internet was around in the 1970s. From its peak on January 11, 1973, the Dow began a two year, 47% slide from 1,067 to its December 9, 1974 low of 570. With no internet or stock market channel, most people continued on saving and investing, cognizant of the losses but not completely panicked or terrified.

Today, the doomsday crowd is calling for the end of the world and a total and final financial collapse. If we were to drop 47% from our high, the Dow would be 2,300 points lower at 7,568. Possible? Absolutely. Anything is possible.

But, like we did after the Great Depression and the 47% drop in 1973 and 1974, and like after so many other times throughout history, we will get through this, great businesses will be more valuable five- and ten-years from now, and price will eventually follow value.

Believe me – there are some very attractive bargains developing in this market, and you should look for them the same way you looked for them when the Dow was at 14,000.

That said, let me paraphrase many investors I talked to last week: Is the world coming to an end?

No, Chicken Little. It will still be here tomorrow. And you have to invest the same way for one simple reason: If everything does go to hell in a hand basket and the US (or your home) economy – and every business in it – fails, your money is worthless anyways. That’s true whether you hold stocks, bonds, cash, real estate. Even gold.

Just ask the fine folks in Zimbabwe. Eleven million percent inflation and growing. Yep – $100 million Zimbabwean dollars invested in gold last year would be worth less than $1,000 today – and that includes gold’s 50% rise in price.

Don’t get me wrong – we face some very tough times ahead. Let me take a quote out of a post I wrote when I was talking about the recession and the US Dollar back in March:

The credit mess needs to work itself out. (Later this week, I’ll talk about how stupid and irresponsible that Bear Stearns, Merrill Lynch, and crew have been for the last ten years.) Regular Joe American who can’t pay his mortgage today ain’t gonna be able to pay his mortgage at the end of higher-price, higher-inflation 2008.

I won’t try to predict the direction of the markets over the next six months. I’ll simply say this:

• Expect high inflation for a while;
• Expect to see some severe market swings – up and down;
• Expect to see trouble in the overseas markets if we do tighten up our trade policies;
• Expect to see trouble in US markets if we don’t;
• Expect to see the US Dollar strengthen if we do tighten up our policies;
• Expect a weaker dollar if we don’t;

Are our problems “fixable”? Yes. Still, it won’t happen in a quarter or two. We went through a trade problem like this in the mid-1980s and it took three or four years of fixing before we entered the boom of the 1990s. By that logic, our next boom would start around 2011 or 2012 – and that’s only if we can solve these more severe problems in the same timeframe.

Looking Down The Road

Five years from now, things will be better. They have to be, because planning for the alternative (total collapse of everything) will virtually guarantee your financial demise.

Think about this: Two weeks ago, Lehman Brothers, Merrill Lynch, and AIG stood tall. Today, they are all but gone. Do you think Johnson & Johnson or Wal-Mart changed their strategy or outlook over the past two weeks? Do you think that people will stop buying healthcare products…from Wal-Mart (the deep discount store)…because Lehman is gone?

At the Pabrai Funds annual meeting (I’ll post about that later this week), Mohnish said:

If you depend on borrowed money, you have to worry about what world thinks of you everyday.

You need to avoid toxic businesses. I can’t value financial companies, and that has helped us avoid this entire mess in financials. Then again, the “mess” reaches far beyond financials. Companies with toxic levels of debt are in for a real treat.

Spreading Beyond the Financials

Long-time readers know that I’ve discussed Amylin Pharmaceuticals a number of times on this site. I got some anonymous hate-mail on those (presumably from some of the management I ballbusted for taking home $21 million plus in compensation while the company’s value continued to decline last year).

Over the past six years, Amylin has increased its long-term debt by about 55% each year, and the shares outstanding have nearly doubled…without a split. In the first six months of this year, Amylin’s interest expense has nearly quadrupled on a 14% increase in revenues.

Amylin has a tough road ahead of it. It owes money to banks…banks that need to charge as much interest as possible to shore up their weak and withering balance sheets. And now, Amylin is between a rock and a hard place. Amylin has to worry about what the world thinks of it.

It can’t sell stock to raise capital. Additional debt is going to cost more than it had in the past. And Amylin can’t generate enough cash to finance its own operations. Today’s buyers of Amylin are hoping for one of two things:

• a miracle drug rushes out of the pipeline, increasing revenues so dramatically that the business can begin generating cash; or,
• a miracle cure to the credit crisis, so Amylin can continue to finance its operations and get their drugs to market.

Otherwise, Amylin will get nickel-and-dimed to financial death, as will many other companies that have to worry about what the world thinks of them.

Maybe there is something to this “buy great businesses” malarkey.

To My Friend Chicken Little

The world isn’t going to end. Sure, we have a long, tough road ahead of us. But, we’ll get through, and great businesses will survive and thrive. Five years from now, we’ll look back and say, “Man – that was crazy. I’m glad that’s over.” Twenty years from now (if not sooner), Wall Street will throw us into another mess, and Chicken Little will poke his head out again.

And if some businesses have to go away, so be it. Just because the stock market falls or stays flat doesn’t mean your investments have to. Invest in businesses that don’t have to worry about what the world thinks about them. As their competitors falter due to massive debt loads, huge interest expenses, and an inability to obtain financing, your businesses will grow more valuable.

Then, you simply have to wait a while. Price follows value, but it doesn’t necessarily happen overnight.

Changes to F Wall Street

Regular visitors will likely notice the redesign here on F Wall Street. I had to make some changes to make it more “user friendly” and get some of those old posts back out here. There is a lot of information on the site, and it gets buried deeper and deeper each time I write an article.

So, here’s what’s new:

• Amazon Banner Ad: Gone. It was slowing down the site and annoying me. We’re back to the old F Wall Street – articles and comments.
• Related Posts: Now appear at the end of each post. This randomly draws four articles in the same category so you can find relevant articles to read when you’ve finished the current article.
• Social Bookmarking: You can now add posts to Digg, Delicious, or Stumble. Admittedly, I have no idea what these are; but, the designer suggested this.
• Add Your Website: If you run a website or blog, you can now add your website to the comments section and it will appear as a link under your name in the comments.
• Latest Comments: They have returned and can be found on the left of the page (under “Categories”) as well as on the home page. You can still subscribe to the comments RSS feed; but, you don’t have to.

Those are the major changes. I hope you enjoy and thanks for visiting (and coming back) to F Wall Street!

Through our investing, we can combat the recession, achieve growth, and keep our heads above water (or fly high). To help us in that endeavor, we must understand the effects of the recession so that we pick the opportunities out of the blood on the streets.

A recession (or worse, a depression) are periods during which the Gross Domestic Product (GDP) of a nation declines for a sustained period (at least two quarters). The formula to calculate GDP is fairly simple:

Let’s take a rational approach to each to see if things will get worse or if we’ve hit the bottom.

Consumer Spending

We know that consumer spending has slowed. We know that it is highly likely to continue slowing, especially as inflation rises and prices get out of control. On CNBC the other night, one interviewee said something to this effect: The consumer may not understand the rate cut entirely, but he sees it as a sign that things are getting better and he’s going to feel better about spending.

Bull.

The reality is that the consumer doesn’t even know the rates were cut. The small minority of us that watch the markets and control our own investing (and have a passion for it) know exactly where the fed rate is and that there have been numerous cuts. Regular Joe American doesn’t give a damn. He’s spending more than he’s saving; his credit card interest rates have not budged (or have risen); prices both at and away from the pump are on the rise; he’s earning spit on his savings account.

Do you think Regular Joe American cares about the rate cut?

The psychological effect of a rate cut (outside of Wall Street) is nothing compared to the psychological effect of the news. Foreclosures. Rising gas prices. Inflation.

My paycheck isn’t cutting it anymore. I really have to tighten my belt. The Fed cut rates again? Great! So why am I paying $4 at the pump? Why can’t I refinance right now? I’m barely keeping my head above water.

From a rational perspective, consumer spending is likely to slow some more. Keep in mind: The doom and gloom in the economy has only been in the news for a few months. As that continues to settle in, consumer spending will likely slow more.

(Not sure? Ask any “regular” person that is not in tune with Wall Street.)

Trade Surplus (Deficit)

When we export more than we import, we add to our GDP. When we import more than we export, we run at a negative. It’s much like personal spending – spend more than you make, and you go into debt. Do it for too long, and you’ll eventually have to downsize. Personally that’s called “bankruptcy”; in the economy, that’s known as a recession.

It’s painfully simple.

Gross Capital Investment

We’re not talking about Regular Joe socking $50 a month into his IRA. Gross Capital Investment is investment in goods that are not consumed, but used for future production. As business investors, we generally understand this as “Capital Expenditures” – investments in plants, property, and equipment that can be used for future production.

The more we import and the less we export, the more we can expect Investment to fall. If consumer spending keeps slowing, there won’t be a need for as much production. (Yes, it’s a slippery slope.) If our exports are strong, Investment can hold up because we can continue to make those Investments and ship the goods overseas.

Government Spending

Government Spending is a combination of Consumer Spending and Investment, only it’s done by the government. If the government is making capital investments or spending money on consumables, that’s generally good for the numbers. Why? In an economy like the US, the government is usually spending that money with US companies that will, in turn, make more Investments and create jobs, thereby increasing wages and allowing Consumer Spending to go up.

(Getting the feeling they’re all tied together? You are absolutely right!)

What’s the solution to a recession?

The solution is well beyond the scope of this discussion; still, you should take away one simple lesson: Get ready to feel some pain.

There is no “one” solution. The stars have to align right – a balance must be made between all of the above. With inflation on the rise (and I expect it to continue for a while, and then stay high for a while), there is money to be made in certain opportunities. Here’s a short list – a starting point:

1. Real estate. It’s a four-letter word right now (which is precisely why you might want to consider looking at it.) As foreclosures continue to rise, people with now-horrendous credit will be looking to rent, and apartment occupancy rates should drop. Building owners that can raise rents to match (or beat) inflation will be able to earn more and more while owing less and less. As I explained to Dan, their cash flows will increase on a real basis while their debts will decrease on both a real and inflation-adjusted bases.
   What’s the move? In the stock market, you may want to look at REITs that focus primarily on residential rental income – preferably ones with strong current and historical balance sheets so there is less likelihood for sub-prime exposure.
2. Basic Needs. Everyone has to brush their teeth, wear deodorant, shave, do laundry, etc. Find the companies that provide basic services to consumers. Apple is nice; still, if the economy turns much worse, expect people to ditch i-Tunes and stop buying i-Phones before they give up personal hygiene. (Of course, we all know that one guy…)
3. Dominance in Basic Wants. When times are tough, you may decide to eat in rather than dining at a Chipotle. But when you need a Coke, you need a Coke. If things get bad, Coke can raise prices to beat inflation. A $15 burrito will drive people away.
4. Parents, Teens, and Tweens. When things take a turn for the worse, parents try to shield this from their kids. Mom may pass on a Coach purse to make sure that junior looks good when he goes out with his friends. If junior is working, he generally has no idea the economy is bad. If he has cash, he’s spending it. Though spending will likely decrease in this area, it will also be one of the first to pick back up.
5. Workouts, and then more workouts. Though workouts can appear at any time, they are most frequent when times are really good and really bad. In the good times, you’ll find a lot of puffy-head management teams trying to make lots of acquisitions because they “should”; in bad times, you’ll find a lot of very smart management teams making acquisitions because they can.

(Note: For 3, 4, and 5 – that’s why Wal-Mart looked so attractive in August of 2007. So long as it is perceived as or remains the place to go for the best price on 3, 4, and 5, it will dominate.)

By now you know that I’m not a bear or a bull, but a realist. I’m not saying we’ve hit the bottom; I’m not saying we haven’t. What I am saying is this: We are presently on a course that will lead us to higher inflation. There will be opportunities along the way, just as there were during and after every recession and depression.

And now you have an idea of where to look.