How Bad Will This Get? The Recession.

March 19, 2008 by Joe Ponzio

Folks, we’re in a recession right now. To paraphrase Warren Buffett, this may not be a recession according to the dictionary definition of the word; still, if you ask the question from a common sense perspective, the answer is painfully clear. During a recession, unemployment generally rises, production slows, spending declines – in short, the happy times slow down and the bad times gain steam.

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:

Consumer Spending
+ Gross Capital Investment (e.g., purchasing machinery,
building a factory)
+ Trade Surplus (Deficit)
+ Government Spending (excluding social security
payments, tax rebates, etc.)
Gross Domestic Product

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.

A Note From Joe Ponzio

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