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Stock Ideas Investors Daily Edge Gaining Perspective in this Recession
Stock Ideas Investors Daily Edge Gaining Perspective in this Recession 
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By Rick Pendergraft This week’s economic calendar pits inflation reports against economic growth reports. These two adversaries have been the focus of the Fed for the past year now, and they have been like two heavyweight fighters going toe to toe. Inflation wins a few rounds and then growth wins a few rounds. |
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| Gaining Perspective in this Recession |
| Friday, 03 October 2008 | ||||||||
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Sometimes you just need to take a break to gain perspective. You could say that was what I did last week, but to be honest, it wasn’t a real “vacation”.You see, I had to do something that most of America is having a hard time doing. I went to the closing for my father’s new home in Puerto Rico. (It took a 20 percent down payment to secure the damn thing. But, when a house costs $60,000, it’s not too difficult coming up with 20 percent.) While I was there, I marveled at the colonial architecture and the ridiculousness of the half-paved streets. I even went to Fort San Cristobal in San Juan and proposed to my girlfriend of nearly three years. I must say, the location was perfect. Ocean views all around. I really outdid myself this time! At the closing, the banker asked me a few questions. His big question was whether it was hard to get a mortgage in America. I nodded yes. Then he asked where he should put his money. Before I get into what I told him, there are some things you should know that will help paint a clearer picture as to what’s really going on. Recession Ahead! If you’re new to IDE, then let me wrap up what all of our editors have been saying since our inception – credit is too lax and we’ll see a big problem. Well, we were right. Last month, consumer spending dropped for the first time since the early 90’s. Considering 2/3 of our economy revolves around spending, this is not a good sign. Sure enough, Morgan Stanley recently came out with a report that says they expect the economy to shrink for the next three quarters… at least. Finally, the street is catching up to the reality of slower growth ahead. It all makes sense, because everything is so tightly connected.
The Credit Bone Connects to… YOU! You see, the economy is like a huge engine. Just like any engine, it has its problems from time to time. Think of credit as the fuel needed to keep the engine running. The more gas that goes into an engine, the faster that engine can rotate. In the same way, the more credit that goes into our economy, the faster the economy is able to grow. That’s because people buy TVs, cars and homes on credit. So consumer spending is directly related to the availability of credit. Not only that, but corporations count on credit to fuel expansions and grow their business. Some corporations, like GE, have so much debt ($556 billion) that it’s imperative for them to pay off huge lump sums as their debt matures. They usually do this by refinancing it, but if corporations aren’t able to access credit, then they begin cutting back, selling off divisions to raise cash, or hoarding cash. What we are seeing today is a shortage of credit. In other words, the gas tank is running near empty. And like most drivers already understand, when a gas tank is nearly empty, you take your foot off the gas and conserve. As banks “let their foot off the gas”, the economy slows. Corporations begin cutting people loose and canceling expansion plans. They upgrade older equipment less often or with products that cost less. As these corporations cut back on spending, it translates into lower profits for any other company that may rely on the big corporation’s spending. In essence, when a big corporation cuts spending and gets rid of jobs, it causes companies relying on them to do the same. So if GM cuts back on spending and eliminates 10,000 jobs, then the parts suppliers that rely on GM have to do the same since there will be less demand for their parts. As these companies start getting rid of their excess workers, it hits consumer spending. Up until recently, this effect hasn’t been a big deal to the economy as a whole. But, since the fall of Lehman Brothers created so many problems in the derivatives markets, credit creation has virtually gone into reverse. As banks deleverage due to huge credit losses, they cut back on the amount of credit that can be created. That means other companies might be unable to gain access to or extend credit lines. Some are even being cancelled. In one example, GE asked Warren Buffet for a $3 billion investment (on top of the $9 billion in stock they decided to sell to the public) just so they could keep up with the interest payments on their $556 billion portfolio of bonds. The Spending Bone Connects to… EVERYTHING! What you have now is a vicious cycle… one of those “negative-feedback loops” that economists always rant about. As corporations lay off workers, those newly unemployed workers have less to spend on everything… rentals at Blockbuster, Big Macs, video games, and even groceries. The lower spending affects other corporations. As those corporations realize lower profits, they then begin to make spending cuts of their own and lay off workers. The result is a rise in unemployment and a further drop in consumer spending. Now, the Big Realization You Need to Make Today This cycle is just getting underway. Even if Wall Street gets their coveted bailout, it won’t stop what’s already happening. The only thing it will do is limit how long and how deep the recession runs. Even if Wall Street is bailed out, it doesn’t take away from the year of tight credit, which we’re still going through. Even if Wall Street is saved, it doesn’t mean banks will happily start lending. And when they do finally lend, they won’t do it as freely as we’ve seen in the recent past. It could take up to three years for the economy to bottom. That’s because everything revolves around credit. When there’s a lack of credit, it hits every corner of the economy. It affects every industry. No one is safe. That’s something everyone has to come to grips with. It’s something that hadn’t become fully clear to me until I left for Puerto Rico. An Island of Perspective As I said earlier, I went to Puerto Rico to help my father close on his home. And while I was there, I only looked at the markets once (it’s tough to keep me away from the markets for more than a few hours!). Your Monday editor, Rick Pendergraft, always told me that sometimes it takes a vacation to see what the market is really doing. That’s because you always come back with a clean slate… and a new perspective. Up until then, I was fixated on what deflation would do to the financial markets as more institutions unwound their open positions. This never changed. But one thing did. I realized how deadly the derivatives market was. I saw how the fall of Lehman caused margin calls in excess of $100 billion a day in the weeks leading up to this bailout. I realized that this was the very reason why AIG needed a government bailout. Because institutions were too busy finding enough cash to meet these Lehman related derivative margin calls. This was one of the biggest reasons why Henry Paulson proposed the bailout. Because if another big institution like Lehman failed, it would cause mass hysteria and panic among other financial institutions, not to mention the general population. This bailout took on new perspective, and its consequences did too. There was no way – in my mind – that congress would fail to pass this bailout. Sure, Monday was a huge disappointment. But considering how dire things really are, I have no doubt that they will pass some type of bailout within the coming days. So what does this all mean? Well, it segues nicely into my recommendation to the banker. Cheap is In As consumers run out of money, they’ll stop shopping at Macy’s and Bloomingdales. They’ll stop trying to improve their image by buying a Lexus they couldn’t really afford. And finally, they’ll look to save cash anyway they can. So is it any wonder that Wal-Mart (WMT) and Dollar Tree (DLTR) have seen impressive same-store sales while every other retailer is lying flat on its back? These two are the king of cheap, and they are growing because of it. But what you need to know is that during the next holiday season… people will spend more money at Wal-Mart and Dollar Tree than any other retailer. After all, cheap is in! They know these two have the lowest prices. I told the banker all of this (in Spanish, of course) and he nodded his head. He understood what I was telling him. I only hope that he listened to the advice. The reason why I’m writing this today, though, is because these are things you need to know to thrive during this recession. Just remember, cheap is in - everything else is just gambling. Stay Free, Charles P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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