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Good times or bad times — investors have a choice

Not all investors will succeed in good times or fail in bad times — it’s all about making the right choices in a new economy, says this advisory.

We start out with a head-scratching scenario. Is the U.S. economy on the verge of boom times or recession? Not many people have been predicting a boom of late. And yet…

“In a featured Wall Street Journal editorial, a renowned scholarly institute told readers that surprisingly weak August employment may reduce September consumption to push third-quarter growth below 2%. Well, the preliminary third-quarter GDP was instead a resounding 3.9%, and the revised GDP report now shows even hotter 4.9% growth.”

That quote comes to us from Richard C. Young’s Intelligence Report. It leads the editor to examine the prospects ahead with one important idea in mind. Investors need not be carried away by the prevailing winds. There are choices. But they must be based on the realities of the situation.

Or as Mr. Young puts it: “For some of you, the next year is going to feel like a recession. For others, opportunities will be abundant, and you will enjoy success beyond your dreams.”

With that introduction, Mr. Young walks his readers through a likely scenario for the U.S. economy in the months ahead. (We scarcely need add that the scenario will have some plot twists in Canada.)

As is our custom, we will also take a brief look at the advisory’s Top 10 Common Stock Countdown.

We begin with the simple fact that the U.S. economy ain’t what it used to be.

Not the same beast

For three decades, Mr. Young tells us, he has been making monthly forecasts based on a consistent set of indicators. The results have “given me a good feel for economic momentum across our economy.”

At the moment, all the factors he analyzes are in negative ground. “Some of the most reliable indicators already signal a recession. The others point to trouble by spring.” Despite that gangbusters third quarter, the fourth quarter and the first couple of quarters in 2008 are bound to show reduced growth.

“You can take some comfort, however, in knowing that today’s U.S. economy is a vastly dissimilar beast to the economy of the 1970s,” adds the editor.

He keeps a chart on the year-to-year rate of change in industrial production going back to the 1920s. There is a remarkable difference between the wide swings in volatility from 1920 and 1950, the slightly lesser volatility from 1950 to 1985, and the relative calm of the last 22 years.

“In recessions of yore,” explains Mr. Young, “inventory management was archaic, and volatility was fierce. The Digital Revolution has changed everything. Cycles are now muted and largely manageable.”

The U.S. export express — and Facebook

So the long-term view is some cause for comfort. What do we see when we look straight ahead?

First, that “housing alone is unlikely to produce a recession.” (If true, this would be further cause for comfort, given the jittery news coming out on Canadian housing.) In the U.S., housing is less than 5 per cent of GDP.

And if housing is going backward, exports are surging ahead. Aided by the weak dollar, exports grew by 19.5 per cent in the third quarter, as compared with 7.5 per cent in the second and a puny 1 per cent in the first quarter of 2007. “The U.S. export express is right on track,” says Mr. Young.

The editor takes this occasion to push home the “shocking difference” between today’s economy and yesterday’s. In the spring, two kids started a music-referral program called iLike on the social network program Facebook. Fortune magazine reported that 10,000 people signed up within three hours, and 10 million within six months. “Just like the old days, huh?” editorializes Mr. Young.

Industrial Revolution and Digital Revolution

Back on the export express, we learn that 20 per cent of U.S. corporate profits came from abroad at the turn of this century. That figure is now up to 30 per cent.

It will grow, says the editor. The big beneficiaries will be blue chips like Boeing (NYSE-BA) and Coca-Cola (NYSE-KO). But there’s even more to the story. The new economy and global growth are working together.

Thanks to “excellent research” from T. Rowe Price, we know that over the last three years global growth has averaged more than 5 per cent annually and emerging market growth has exceeded 7 per cent, “closely imitating the industrial revolution that began to sweep through the developed world some 200 years ago.”

Thus, despite the scary scenario for the U.S. over the next few quarters, the global economic scenario, paired with the Web’s Digital Revolution technology, “offers profound promise for astute investors,” concludes Mr. Young.

The big banks look like start-ups

To take advantage of that premise, we must know where we are in the credit cycle. To be sure, credit market jitters aren’t going away in a hurry. “Investors are scared and panicked,” says Mr. Young. “Fear and emotionalism are prevalent.”

In some cases, the results are downright bizarre. “The stocks of some of the world’s largest banking institutions are being treated like start-ups.” (We reported a similar story on the big Canadian banks earlier this week; Daily Buy-Sell Adviser, January 8.)

“But the volatility in financial stocks signals the end of the credit cycle,” insists the editor. “When the credit cycle ends, banks start to clean up their balance sheets. Bad loans made during good times are written off, and focus shifts to rebuilding capital. The actors in every credit cycle change, but the story is always the same.”

In the last credit cycle, the writedowns were on technology and telecom loans. In the one before that, they were on emerging market debt. Before that, it was commercial real estate, and even before that, in the 80s, it was energy firms.

Now, of course, the culprits are collateralized debt obligations (CDO), asset-backed securities (ABS) and structured investment vehicles (SIV). We will not re-hash the shabby story of these debt vehicles, which has been told here and elsewhere many times. But Mr. Young does make a very interesting point.

The geniuses who came up with these “structured” vehicles made one huge mistake. They forgot that they weren’t really sitting on the sidelines.

Not clever enough

The key to structured finance, says Mr. Young, is “securitization,” the pooling and resale of loans. Basically you turn hundreds of loans into bonds and sell them to someone else. They’re off your books.

What’s more, you don’t have to worry about credit analysis. You can loan money to anybody, regardless of employment, credit history and income verification. It’s not your problem. You’re passing the loan on to somebody else.

Clever. But not clever enough. Because, says Mr. Young, when you start throwing money into the market, you can change the market in ways you didn’t foresee. And that’s exactly what happened.

When the originators started handing out money indiscriminately, “the behavior of the borrowers changed — condo flipping comes to mind. The CDO modelers never thought to account for the adaptive nature of markets. Ph.D.s struggle with such a concept.”

The Nobel Prize winners who developed Long Term Capital Management in the 1990s made the same mistake. “Both groups overlooked the impact of their own participation on the market. When actual defaults started to come in higher than the models estimated, the demand for CDOs evaporated, and the cycle turned.”

The result is that big financial institutions like Citigroup (NYSE-C) and Bank of America (NYSE-BAC) are now taking big writedowns. But don’t cry for these banks. As the credit cycle unfolds, the weak hands will fold and the strong ones will prevail. Says Mr. Young: “The cheapest place in the stock market right now is in the sectors that are being punished.”

In effect, Mr. Young has put together a scenario in which every black cloud has a silver lining. In this scenario, cycles continue to go up and down, but a brave new economy ensures that the effects are not as devastating as they were in the past. Rather than dwell on the problems ahead, astute investors can choose the right opportunities.

Speaking of opportunities, we will close with a brief update of Mr. Young’s Top 10 Common Stock Countdown.

January’s Top 10

Here are the ten best stocks for American investors today, in the opinion of Mr. Young.

1) Johnson & Johnson (NYSE-JNJ).
2) Plum Creek (NYSE-PCL) harvests trees and develops land – it is the largest landowner in America.
3) Illinois Tool Works (NYSE-ITW).
4) McCormick (NYSE-MKC), food maker, just bought Lawry’s brand of marinades and mixes from Lawry.
5) Black Hills (NYSE-BKH), energy holding company bought Aquila assets that expand it into 12 states and Canada.
6) Nestlé (OTC-NSGRY).7) Rayonier (NYSE-RYN), a forest products company that also develops real estate and makes commercial fibres.
8) General Electric (NYSE-GE).
9) PepsiCo (NYSE-PEP).
10) Hormel Foods (NYSE-HRL), one of America’s biggest sellers of meat products.

Note that while Mr. Young paints a relatively optimistic picture over time, in the short term he opts for prudence. His list of top stocks heading into the uncertain times ahead includes a fair sampling of so-called “consumer staples,” those recession-proof products people can’t — or won’t — do without.

Even in a new economy, old habits may be hard to break. Investors may wish to run and hide in the face of uncertainty, but if this advisory right, it is not bad times you have to worry about, just bad choices.