But does that mean it's a bad time to buy stocks? Not necessarily. We've had nine recessions since 1950. If you had put $1 on the S&P 500 every month since 1950, your $695 would be worth roughly $11,192 today. But if you had the discipline, foresight, or luck to have broken up the $695 into nine equal chunks--buying the S&P 500 at the outset of those nine recessions--you would have about $13,750 today, or 22% more. Inflation would have taken a large chunk of that change, but putting your money to work in the market sure would have beaten stuffing i
t under a mattress.
Granted, past performance does not guarantee future success. In turn, it is also true that if you had waited for a few months after those recessions had started before buying into the S&P 500, you would have even done a little bit better. But buying stocks at the beginning of recessions can make sense. The S&P 500 is in the index of leading economic indicators for a good reason. Stock prices tend to go down before recessions begin, and appreciate before recoveries get under way. The signal is clearer on recoveries than on recessions, but that is part of the point.
In this article, I'll take a look at some of the most prominent recent recession indicators, then talk about the types of companies that we look for in this kind of environment.
Tracking the U.S. Economy: The Building Blocks
Gross domestic product (GDP) measures the total value of production in a given period. GDP includes consumption, investment, government spending, and net exports. It can be estimated with a spending approach or an income approach, which in theory should be roughly equal as one person's spending leads to income for others. In practice, the spending approach is emphasized because spending data is timelier. But both the spending and income methods attempt to get at the same thing--the real value of economic production.
The income-based approach to GDP helps illustrate how corporate earnings fit into the overall economy, and how trends in both can matter for investment choices. Concern about a corporate "earnings recession" has recently been spreading and intensifying. If you are rooted in P/E as a valuation metric relative to, say, anticipated growth rates or prevailing interest rates, we don't think you are necessarily wrong. But when entering an economic downturn, a focus on P/Es based on recent or near-term earnings forecasts can mislead, especially as analysts slash their earlier forecasts.
At Morningstar, our equity analysts emphasize a longer-term approach, and our discounted cash-flow (DCF) models extend out five to 15 years. We think the DCF approach helps us frame our thinking where it belongs--in longer-term trends. We know they are difficult to capture with precision, but they matter most for performance over time.
Our fair value estimates add two numbers: the present value of the discounted cash flow over a forecast horizon, and the present value of a long-term "perpetuity" at the end of the horizon. If one of our analysts builds slowing activity into sales and earnings expectations over the next year or two, that will play into the valuation. But so will longer-term cash flows, and the latter help root our valuations at times when P/E-based valuations are focused too closely on near-term doom.
We also search for companies with "economic moats," which are firms that can produce durable economic returns through time. By "economic" returns, we are looking for firms that produce returns on capital in excess of the cost of capital. This does not necessarily mean we are looking for firms that are immune to recessions. Economic moats tend to insulate the best firms from the worst things that recession and inflation can throw at them. But some of the firms we like the best from a moat perspective are very sensitive to economic cycles.
So, How's the U.S. Economy Doing?
In the third quarter, U.S. GDP is currently estimated to have risen at an annualised rate of 4.9%, up from a previously estimated rate of 3.8%. Business fixed investment spending and net exports were particularly strong. But inventory expansion made an outsized contribution, and more recent incoming data have been setting off alarms.
Housing
Housing is a bellwether component of GDP, and resides in the "investment" category. Housing tends to lead overall economic results, especially at economic turning points. The recent housing news has been, well, very bad:
- Residential Fixed Investment: With the preliminary estimate for third-quarter 2007 GDP now in, the U.S. have had seven consecutive quarterly declines in residential fixed investment. Since World War II, the country hasn't had a string of declines this long and severe without a coincident, or imminent, national recession. In the past year, permits for new housing starts have fallen sharply.
- Existing Home Sales: GDP is based on current production. Used car sales and existing home turnover do not directly enter into GDP, except for the services produced by dealers and realtors. But housing turnover has important indirect effects on retail sales and other services activity. The news here isn't good, either. Existing home sales fell for the eighth straight month in October, falling 21% below year-earlier levels, reaching the lowest sales pace since 1999.
- New Home Sales: New home sales tend to provide more timely reads on housing activity, as they are based on contracts signings, not closings. In October, new home sales remained essentially flat with September levels, which had reached the lowest annualized sales pace in 12 years. More ominously, the median sales price of a new home fell by the most for a single month in October since 1970, a nasty recession year. 1970 may feel like yesterday for some of us but this means October had the biggest monthly price drop in 37 years.
- Housing Prices: Many markets around the country are experiencing flat to slightly higher prices. On average, however, prices are declining significantly, and the declines seem likely to get more pervasive. According to the Case-Shiller Index, a national average of U.S. housing prices fell at a particularly sharp 17% annualized rate from the second quarter to the third quarter. Derivatives contracts are pointing to further deterioration in the year ahead.
- Foreclosures/Credit Quality: There are few signs of any recent improvement on this score. On Nov. 29, data services firm RealtyTrac reported that home foreclosure filings nearly doubled in October from a year earlier. On Nov. 30, the Mortgage Insurance Companies of America reported that the default rate on insured mortgages rose to the highest level since August 2001, amid the last recession. In early December, the Mortgage Bankers Association reported that new foreclosures hit a record high in the third quarter, and for the second consecutive quarter.
From an economic standpoint, consumer durable goods are another good thing to watch. They tend to be "cyclically sensitive," rising faster than overall spending when times are good. Bad times hit durables harder. Most purchases are able to be postponed, and they tend to be on bigger-ticket items sensitive to income and confidence trends. They are also quite sensitive to the supply of credit, a significant issue in recent months. Like housing, consumer durables tend to lead overall economic activity.
- Cars: The unemployment rates in the American states of Michigan and Ohio are among the highest in the nation right now, and for a good reason. The vehicle market is softening significantly. The latest sales rates are running roughly 10% below their mid-2005 peak. Car loan delinquencies have recently started rising, and Ford and GM each recently announced significant cuts to their production plans for the first quarter of 2008.
- Recreational Vehicles: RVs are especially sensitive to overall economic trends, particularly when the economy is impaired as it has been lately by high energy prices and reduced credit availability. For 2007, manufacturer shipments of RVs to dealers look like they will be down about 10% from last year, and industry analysts have been scaling back their forecasts for 2008 considerably.
- Appliances: The Association of Home Appliance Manufacturers puts out a monthly shipments report, albeit with bit of a lag. Their latest data show that shipments declined 6% for the first three quarters of 2007 from the same period in 2006. Recent reports from retailers like Sears suggest intensifying weakness in this area more recently.
While emphasizing the importance of fundamentals in American football, the much revered Greenbay Packers coach Vince Lombardi once said, "Statistics are for losers." Block and tackle well, and the statistics will take care of themselves. What can investors learn from Lombardi on this one? Don't let the statistics get to you too much these days, either in earnings or overall economic reports. For investors interested in developing their own portfolios, that means seeking out individual companies that block and tackle well--no matter what the score is. A few bad breaks can put a team behind. For companies, the slowing economy can make for tough sledding, and executing on fundamentals gets even more important.
But that doesn't mean we can ignore the economy, either. When interpreting results, we have to try to account for the influence of factors within the control of the company, and those outside of it. Slowing sales don't necessarily mean slowing performance. Good companies can shine, relatively speaking, in a tough economic environment. At Morningstar, we believe that a firm's economic moat gets even more important in times of economic weakness or inflation.
Squinting Ahead
A few things are worth keeping a close eye on for evidence of a developing recession. Consumer spending makes up more than half of total GDP, and it makes sense to watch if weakness in spending spreads beyond durable goods. It will also be worth watching business investment spending, particularly on equipment. Business investment spending held up quite well in the third-quarter GDP report, but it can turn on dime in a developing recession. We'll be keeping a close eye on this statistic going forward.
