How Will the Recession End?

by: Zacks Investment Research

by Dirk van Dijk

The economy is in awful shape right now, but it is not in a terminal decline from which it will never recover. We have faced hard times before and always managed to come out stronger on the other side. While I do believe in happy endings, I do not look for one right around the corner.

Waiting for the recovery does not mean sitting on your hands and doing nothing. There are things that you can be doing today to help yourself prosper for the long run. Indeed, now may be the best time in your life to make moves that will help you have greater wealth later in life.

The stock market almost always turns up before the economy does. Trying to pick the absolute bottom is a fool's game. We are far enough along in the process that it is time to start tiptoeing back into the market.

Remember that a bear market is a long term investor's best friend. Only in bear markets do serious values appear.

Why the Recovery Will be Slow

The timing and shape of the eventual recovery will play a very important role in the success of your portfolio. In trying to figure out how and when the recession will end, it is useful to look at how other recessions have come to an end.

In every recession, the part of the economy that gets moving first is residential investment, which is mostly the construction of new houses. Existing home sales, which make up about 7 of every 8 home transactions, also tend to start rising at the same time. (Existing home sales, however, are pretty much irrelevant to GDP growth since no construction is taking place.)

The graph below shows that both new and existing home sales tend to bottom in recessions and then rise sharply, helping to drive the economy out of the recession. The dramatic decline in both was the biggest clue that a recession was coming.

The next thing to get going is consumer spending, particularly on big ticket stuff that people do not buy every day. The classic example of this is auto sales.

Business investment tends to lag behind and, at best, moves with the overall economy (e.g. software and equipment investment) or after the rebound has firmly started (e.g. investment in new office buildings and stores).

The unemployment rate lags economic cycles and tends to rise even after a recovery gets underway. Still, employment will normally start to improve faster than investment in non-residential structures. Non-residential construction has just started to turn down, and has much further to fall.

Home Prices, Not Starts, Are Key

So, in looking at February's shocking news that new home starts jumped by 22.2% over January, does it mean that happy times are here again? Sadly no and I actually consider this to be extremely bad news.

At the January sales pace (the February data will be released on Wednesday), it would take 13.3 months to clear the existing inventory of new houses. Never before in history has the months of supply of new houses even exceeded a year.

So while in the short term, the rise in starts is good news for the homebuilders like D.R. Horton, Inc. (NYSE:DHI) and Lennar Corporation (NYSE:LEN), over the longer term it is bad news. Do not pay attention to the recent speculation into these companies, or in the major suppliers to them, like Masco Corporation (NYSE:MAS) or Fortune Brands, Inc. (FO).

Put another way, we have to remember the first law of holes. If you find yourself in one, stop digging. In this case literally, we need to stop digging new foundations.

Now perhaps it is not quite as bad as the numbers look at first blush. Housing starts are a notoriously inexact statistic. However, in the absence of better information we have to assume the up 22.2% number is correct. Also, most of the new construction being started is for apartments and condos. Single family starts were only up 1.1%, while starts in structures with 5 or more units were up 79.7%.

These new apartments and condos will be competing with the existing stock of new houses for sale, and with existing homes, an increasing number of which are distressed sales, in or near foreclosure. Housing prices fell by 18.5% in 2008, as measured by the 20-metro area Case-Shiller Index. This plunge was a major factor in the $11 trillion loss of wealth in the country in just the fourth quarter.

On the other hand, is it a good time to be buying a house? Not really, based on long standing relationships between the price of a median house and median incomes. Furthermore, based on the historical relationship between what it would cost to rent or buy a comparable house, nationwide housing prices still probably have another 15% or so downside to them. A flood of new apartments coming on line will only further depress the natural equilibrium price for housing.

Consumers Not Eying Big Purchases

That loss of wealth is going to make people try to save more out of their current paychecks. Saving more can be tough when one or both spouses have lost their job, but many consumers don't have a choice. The retirement plans of all but the wealthiest baby boomers have just been severely disrupted. The 401K has become a 201K, and the equity they once had in their houses is gone. While the assets might be gone, the debt lingers on.

The last thing a worried consumer is going do is go out and take on $25,000 of more debt to buy a new car. Rather he will keep the old one running for a few more years.

Keep in mind that the quality of new cars, both U.S. brands like General Motors (NYSE:GM) and Ford Motor (NYSE:F) and foreign nameplates like Toyota (NYSE:TM) and Honda (NYSE:HMC) has improved dramatically since the last recession we had of this magnitude, back in the early 1980s.

Yes, the current sales rate of under 10 million light vehicles is probably unsustainable over the long term, but that does not mean that we will have a strong rebound in sales soon.

The only thing that the economy really has going for it right now is the economic stimulus package. This will keep the incomes of those hardest hit by this downturn somewhat intact so they can continue to spend on necessities. Most people will get a small tax cut, and they might even spend some of that.

The package should help to prevent state and local governments from dramatically cutting back services or raising taxes to balance their budgets. It will spur the overhaul of our long neglected infrastructure. We will start to improve our energy efficiency and produce renewable power sources. This will keep the economy alive, but on life support.

From a low base, it is likely that the GDP will start to grow again towards the end of this year and into 2010, but the pace of that growth will be extremely anemic. Unemployment will continue to rise even as the economy starts to grow.

The low interest rates and loose monetary policy being pursued by the Federal Reserve will at least help in this life support mission.

Eventually people will feel they have saved up enough, and their old goods are in such dire states of disrepair, that they start to spend again. But we still have a ways to go before enough demand gets pent up that we can get the economy going full bore. Time heals all wounds, even deep economic ones.

What to Do Now

I would suggest dollar cost averaging in over a period of about 6 months. So if you have $30,000 you want to invest, put $5,000 of it to work each month. This is far more advantageous than trying to pick an exact bottom, which is impossible.

Stick with only those firms with strong balance sheets and which make products for which there is a steady demand. As a shareholder, you are part owner of all the assets of the firm. A firm with lots of cash will be able to take advantage of the bad economy. Its weaker competitors will be forced out of business or greatly weakened. The stronger companies will be able to scoop up the bargains that become available and gain market share.

Key Sectors

The first sector I would be looking at would be health care, closely followed by consumer staples. Think of companies like Johnson & Johnson (NYSE:JNJ), St. Jude Medical, Inc. (NYSE:STJ) and Colgate-Palmolive Company (NYSE:CL). The economy would have to be in very desperate straits for people to stop buying band-aids, decide not to get a needed heart valve replacement or stop buying toothpaste.

There are also some interesting investments available in the electric utilities. Zacks Equity Research currently has buy recommendations on Allegheny Energy, Inc. (AYE) and Sempra Energy (NYSE:SRE).

I would continue to avoid the financial and consumer discretionary sectors. I fear that there are many more write-offs to come in the financial sector, particularly as commercial real estate starts to decline.

If you are determined to play the financials, I would advise buying the bonds of banks, not the common stock. The common stock is likely to get diluted, but it is clear that the government is not going to let major banks go bankrupt, which makes the bonds very safe investments. Plus the current worries have their bonds trading with high yields.

The consumer discretionary sector is filled with companies where consumers can easily go on strike for a while. Given the need to rebuild savings, they could be staying away in droves for a long time.

Understand that the longer your time horizon, the more likely it is that your investments will pay off. The time to buy stocks is when they are on sale, even if they get marked down further in the short-term. We may not be out the woods, but we will emerge out the current crisis in better shape.