Don't Fear a Recession

I tried to express my thoughts in a simple diagram.

The last few years have been artifically stimulated demand (the bubble demand I indicate above). Call it the housing economy: part house sales and part home loan boosted consumer spending. Home sales contributed 5.5% to the GDP in 2006. That dropped to 5.1% in Q2 of 2007.

In other words - the GDP was artificially inflated by the simple fact of more home sales at higher prices. With fewer home sales, GDP will naturally drop. So negative growth is inevitable and in and of itself not a problem. The underlying economy continues to roar away, in normal cases.

Where it becomes a problem is the second bubble I chart above. Bumping up housing today is really borrowing from tomorrow's demand. That's a bit of a systemic problem for the longer haul for the construction, financial and real estate sectors.

But a bigger problem is that the housing economy included borrowing against that asset (and other excesses). Again, that is what boosted the GDP and made it appear robust. Remove that spending and GDP drops. The only other option is for folks to buy more cars, iPods and so forth. Dump that 3 year old furniture and buy a new set.

But that isn't goingto happen. So GDP will drop.

We shouldn't worry about a slowing GDP caused by slowing housing sales - that's just math. We should worry about the drop in consumer spending. That's when recessions lead to broader economic slowdown.

I believe that massive rate cuts will spur some spending. For example, I bought a car last year and used a credit card offer by Citibank to transfer a balance and pay 0% interest for 12 months. I just got another offer, good for 15 months. I'm going to use that one next. A low interest rate enables these offers. And it frees up my cash for other things to buy.

This reduces the severity of the broader recession.

As more information comes out, focus on consumer spending habits and not on the GDP number.

Weak Retail Sales & Lower Interest Rates

As expected, retail sales were the slowest since 2002.

For consumers, this is actually good news. Retailers will need to dump inventory and lure shoppers. There will be some good deals out there.

Another important thing to consider is the overall impact that this has on the economic psyche. The steady drumbeat of negative news will have lasting impact and add to further belt tightening and cautious spending behavior.

------------------------------
More interest rate drops on the way. And deep ones.
I'm still thinking this through, but I think it is good and bad. A lower rate reduces the housing re-set pain. It lowers banking carrying costs. That is a big advantage.

But will it re-inflate spending and re-inflate the housing market? Somewhat, but not to the desired degree. Borrowing and spending can continue, but not at the same pace.

For housing, the damage is done.
1. Real demand is lower than was experienced - That is, speculators are gone and they were 20%+ of the market (some reports say 30%)
2. Folks get locked in - Lower rates may prevent more foreclosures, but it does nothing to boost demand. Those folks are still locked in. And people now know how fragile and how scary real estate is - they aren't going to rush in.
3 Lending terms are tighter - Money just won't be available on the same terms.

Yikes

The market is collapsing. If you bought the put suggestions that I offered, good for you. You doubled your money in 1 day.

It's tough being long in this current market. I don't think the market is oversold. I did expect this week to have a bit of a dead-cat bounce, so the rapid collapse is surprising. Also, with earnings coming out, I expected some consolidation.

I look at Intel and ATT and see some telling stories. ATT announced yesterday that they are facing a rash of unpaid cable and phone accounts. That is consistent with the belt-tightening I have predicted for so long. What is interesting is the tone of ATT's announcement - they defensively protest that they will hit earnings. Intel hit the same notes last week when they announced that they will hit numbers thanks to global demand. It echoes Cisco's own earnings release protests that all is fine.

Investors are saying that they don't care about this quarter - they care about the next few quarters. If ATT is showing signs of weakness, then won't that affect capital spending plans and hiring plans? And that's how recessions start - with consumer spending slowdowns that lead to industrial investment slowdowns.

And every day the drumbeat of negativity continues. Today it was GRMN.

The stocks in the portfolio should be immune from long term US recessionary trends. But I am still stunned by the collapse of WFR, FWLT and others. All of these stocks are what I call undervalued growth stocks: PEGs <1,>30%, not dependent on US market. I think a few solid earnings announcements will reverse the market's pessimism towards all stocks and reward the true growth stocks.

What to Short

Obviously the market is in a negative mood. This will translate into lower P/Es:
* Return to fundamentals - PEG must be ~1. That is, stock prices will return to a point where future growth is greater than or equal to P/E.
* Prices to drop - Whether because P/Es exceed growth expectations or because of lowered growth expectations, stock prices will continue to drift down

So I am looking for stocks where PEG >1 and/or where growth rates are under threat. There are 3 major trends that will lower growth rates:
1. Consumer spending reductions
2. Housing related
3. Corporate IT related

Before I go to the list, lets talk tactics.
I am assuming that the pattern will resemble the last bubble recession. So where are we?

http://finance.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=1&chfdeh=0&chdet=1199650815000&chddm=1004088&q=INDEXDJX:.DJI

In the last recession
* Year 1 (2000) a transition period with the market barely moving
* Year 2 (2001) recession begins and Dow has sizeable swings, falling as much as 20% before rising. But each drop was lower and lower.
* Year 3 (2002) Dow collapsed 30%

I would argue that we won't see a 2 year transition this time (i year flat and 1 year down). With the internet driving information faster, coupled with a much more significant bubble, I think the fall will be faster. A 1 year transition marked by a 15% drop. If we are now in month 3 of this year 1 and if we can expect a 15% total drop, then we should expect a further 10% drop over the next 9 months.

But the transition year is marked by large up and down swings. To avoid getting caught buying a put during an upswing, my approach is to buy puts that expire 5+ months out. I am trading off risk for reward. Now, this next point may seem contradictory, but I also don't necessarily want to hold to expiration. The extra time I am buying is insurance, that is all. The market could find some strength for a month, and we need to be able to outlast that.

Overall, I think a lot of opportunity remains to buy puts and to do well. I think the mood will get uglier in 2 quarters as exconomic growth stagnates further.

One final point. I looked at strike prices that were close to or just out of the money. With some little variation, the June puts require a 16% drop in stock price to reach breakeven. That would be within the range of expectations: although 2001 ended with a 10% drop, there were deeper drops throughout the year. Obviously, an even lower strike price is cheaper. My thinking is that we just had a major drop and there may be a dead cat bounce, so anything far out of the money is actually too risky.

THE BLUE COLLAR RECESSION
I have been dead-on correct that we are in a blue collar recession. I predicted the increase in unemployment, and that's what chilled the market this week. So let's be clear about what is coming down th epipe: belt tightening.

RETAILERS
All retailers will be challenged to make their sales numbers, and all will do so only by sacrificing margins. They are already hit hard, but the damage has yet to start because they have relatively high PEs. Assume flat income growth at best. In which case any retailer with a PE > 10 will get chopped down to size.
But be careful - many will protect income by layoffs and store closings. That helps a bit (look at Radioshack or Pier 1) but it doesn't grow sales. They will squeeze suppliers next, so that's a logical place to look as well.
Saks (SAKS)
Macys (M) - $10B debt on top of retailer troubles
Sears (SHLD) - The June $100s are $12.80
Zales (ZLC)
Radioshack (RSH) - The first retailer to try to tighten operations. The effects are already done - so they have no more upside.
Home Depot (HD)
Pier 1 (PIR) Still room to drop

AUTO
Honda (HMC) - They make off road vehicles, motorcycles and cars and trucks. That plus a strengthening yen.
HOG - Harley is toast
TRW - They are slowing down
Auto Nation (AN) - Car sales will be drying up
Carmax (KMX) - Large used car dealership


RECREATION
I've been saying for months: boats, jet skis, and so forth are play toys that will be suffering.
west marine (WMAR) - Boats
winnebago (WGO) - RVs are already hit but there's still room to drop
thor (THO) - RVs are already hit but there's still room to drop
arctic cat (ACAT) - Gone, baby, gone
carnival cruise (CCL) - Business in the Spring will be bad
Lifetime fitness (LTM) - Will folks be cutting back on gym dues? At the very least, fee hikes will be hard to charge
MGM Casinos (MGM) - I see a slowdown in Vegas excurions and conventions. Plus MGM hasn't yet been hit by a downturn in stock price.

INSURANCE
Fewer houses being covered. Reductions in insurance coverage on autos, property and health.
American (AIG)
Prudential (PRU)

RESTAURANTS
A lot less dining out
Middleby (MIDD) - This is a Motley Fool darling, and rightly so. Except that I think restaurants will start pushing out orders for new equipment. This is one of the few stocks I've considered that has not been hit yet. Which makes it a good target.

EMPLOYMENT
Monster (MNST) - Companies will start cutting back hiring plans.

HOUSING
Masco (MAS) - Cabinets? Home furnishings? Not likely

IT CUTBACKS
Hewlett Packard (HPQ) - Much of the business is locked in (leases) but growth is nowhere. And some companies will simply be going out of business
Palm (PALM) - Dead man walking

OTHER
Gannet (GNI) - Lower advertising revenue for newspapers
Select Comfort (SCSS) - A $2000 bed? Pass.

What to Short

Obviously the market is in a negative mood. This will translate into lower P/Es:
* Return to fundamentals - PEG must be ~1. That is, stock prices will return to a point where future growth is greater than or equal to P/E.
* Prices to drop - Whether because P/Es exceed growth expectations or because of lowered growth expectations, stock prices will continue to drift down

So I am looking for stocks where PEG >1 and/or where growth rates are under threat. There are 3 major trends that will lower growth rates:
1. Consumer spending reductions
2. Housing related
3. Corporate IT related

Before I go to the list, lets talk tactics.
I am assuming that the pattern will resemble the last bubble recession. So where are we?

http://finance.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=1&chfdeh=0&chdet=1199650815000&chddm=1004088&q=INDEXDJX:.DJI

In the last recession
* Year 1 (2000) a transition period with the market barely moving
* Year 2 (2001) recession begins and Dow has sizeable swings, falling as much as 20% before rising. But each drop was lower and lower.
* Year 3 (2002) Dow collapsed 30%

I would argue that we won't see a 2 year transition this time (i year flat and 1 year down). With the internet driving information faster, coupled with a much more significant bubble, I think the fall will be faster. A 1 year transition marked by a 15% drop. If we are now in month 3 of this year 1 and if we can expect a 15% total drop, then we should expect a further 10% drop over the next 9 months.

But the transition year is marked by large up and down swings. To avoid getting caught buying a put during an upswing, my approach is to buy puts that expire 5+ months out. I am trading off risk for reward. Now, this next point may seem contradictory, but I also don't necessarily want to hold to expiration. The extra time I am buying is insurance, that is all. The market could find some strength for a month, and we need to be able to outlast that.

Overall, I think a lot of opportunity remains to buy puts and to do well. I think the mood will get uglier in 2 quarters as exconomic growth stagnates further.

One final point. I looked at strike prices that were close to or just out of the money. With some little variation, the June puts require a 16% drop in stock price to reach breakeven. That would be within the range of expectations: although 2001 ended with a 10% drop, there were deeper drops throughout the year. Obviously, an even lower strike price is cheaper. My thinking is that we just had a major drop and there may be a dead cat bounce, so anything far out of the money is actually too risky.

THE BLUE COLLAR RECESSION
I have been dead-on correct that we are in a blue collar recession. I predicted the increase in unemployment, and that's what chilled the market this week. So let's be clear about what is coming down th epipe: belt tightening.

RETAILERS
All retailers will be challenged to make their sales numbers, and all will do so only by sacrificing margins. They are already hit hard, but the damage has yet to start because they have relatively high PEs. Assume flat income growth at best. In which case any retailer with a PE > 10 will get chopped down to size.
But be careful - many will protect income by layoffs and store closings. That helps a bit (look at Radioshack or Pier 1) but it doesn't grow sales. They will squeeze suppliers next, so that's a logical place to look as well.
Saks (SAKS)
Macys (M) - $10B debt on top of retailer troubles
Sears (SHLD) - The June $100s are $12.80
Zales (ZLC)
Radioshack (RSH) - The first retailer to try to tighten operations. The effects are already done - so they have no more upside.
Home Depot (HD)
Pier 1 (PIR) Still room to drop

AUTO
Honda (HMC) - They make off road vehicles, motorcycles and cars and trucks. That plus a strengthening yen.
HOG - Harley is toast
TRW - They are slowing down
Auto Nation (AN) - Car sales will be drying up
Carmax (KMX) - Large used car dealership


RECREATION
I've been saying for months: boats, jet skis, and so forth are play toys that will be suffering.
west marine (WMAR) - Boats
winnebago (WGO) - RVs are already hit but there's still room to drop
thor (THO) - RVs are already hit but there's still room to drop
arctic cat (ACAT) - Gone, baby, gone
carnival cruise (CCL) - Business in the Spring will be bad
Lifetime fitness (LTM) - Will folks be cutting back on gym dues? At the very least, fee hikes will be hard to charge
MGM Casinos (MGM) - I see a slowdown in Vegas excurions and conventions. Plus MGM hasn't yet been hit by a downturn in stock price.

INSURANCE
Fewer houses being covered. Reductions in insurance coverage on autos, property and health.
American (AIG)
Prudential (PRU)

RESTAURANTS
A lot less dining out
Middleby (MIDD) - This is a Motley Fool darling, and rightly so. Except that I think restaurants will start pushing out orders for new equipment. This is one of the few stocks I've considered that has not been hit yet. Which makes it a good target.

EMPLOYMENT
Monster (MNST) - Companies will start cutting back hiring plans.

HOUSING
Masco (MAS) - Cabinets? Home furnishings? Not likely

IT CUTBACKS
Hewlett Packard (HPQ) - Much of the business is locked in (leases) but growth is nowhere. And some companies will simply be going out of business
Palm (PALM) - Dead man walking

OTHER
Gannet (GNI) - Lower advertising revenue for newspapers
Select Comfort (SCSS) - A $2000 bed? Pass.