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Economic Forecasts

The Silver Lining

Investors with a time horizon of at least five years can be confident the market will come back.

Is the U.S. in a recession?

The official answer comes from a sort of Supreme Court of seven economists, who decide whether a "significant decline in economic activity spread across the economy, lasting more than a few months" has occurred. A more precise, but strictly unofficial, definition of a recession is two consecutive quarters of decline in gross domestic product, which is the total output (after inflation) of the nation's goods and services.

As I write, we haven't had that: The first quarter of 2008 registered growth of 0.6%. But that figure is subject to revision, and it's possible a recession started sometime in the waning months of last year.

The essentials

Still, if this is not a recession, it certainly seems like one. As an investor, here is what you need to know. First, a recession should be seen as an opportunity to make money. Second, recessions have tended lately to be infrequent, short and shallow. And third, recessions always end.

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Analysts at T. Rowe Price looked at the last ten recessions and found that the median increase in stock prices (using the benchmark Standard & Poor's 500-stock index) six months after the market hit its low point was 24%. Twelve months after the low point, the median rise was 32%.

Of course, those gains assume you know where the low point is. Then you have the problem of knowing when the recession began. Frequently, the wise men don't tell you it has started until it's over.

Let's look at the current situation. The S&P hit a closing low on March 10 of 1273. At the end of May, the index was more than 100 points higher. If we assume that the S&P does not retreat below the March low and that a recession has indeed begun, then, based on the historical averages, the economic downturn began late in 2007 or early in 2008. Under such a rosy scenario, we should see the S&P climbing to about 1680 -- easily an all-time record -- and an equivalent rise to about 15,500 on the Dow by March 2009.

But if we view history another way, there's an unsettling possibility: The recession didn't get going until the spring, and, if so, the stock market still has a way to go down. On average, the S&P peaks about seven months before a recession starts. The peak in this cycle was early October; that would indicate a recession commencement date of April and a stock-market bottom around this coming November.

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As I have said many times in this column, market timing is a game for fools. What we do know is that, historically, stocks start to recover before a recession ends, so when you are feeling particularly wretched about the economy and the headlines are filled with gloom and doom, you should start buying stocks. Or, to put it another way, the middle of a recession is one of the worst times to be selling stocks.

Says Tim Hayes, chief investment strategist for Ned Davis Research, "By the time the recession has gotten well under way, the market has mostly priced in the bad news." The time to be selling, if you are a genius market timer, is about a half-year before the recession starts. Good luck.

Receding recessions

But there is something else about recessions to consider: They seem to be getting shorter. The National Bureau of Economic Research has recorded 32 recessions since 1854, and their average duration was 17 months. But the ten recessions since 1945 have lasted, on average, just ten months.

More remarkable is that there were eight recessions between 1948 and 1982, or an average of one every four years, but between 1982 and 2007, there have been only two recessions, an average of one every 12 years. These last two recessions have been short (eight months each) and mild. In fact, in the past quarter-century, the U.S. economy has failed to grow (after inflation) only in 1991.

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The most important thing to know about recessions, however, is that they eventually end. And after they do, stocks rise to higher levels than before the recession. The time it takes for stocks to recover to their prerecession peak varies wildly: In the past ten recessions, recovery has taken from two months to 67 months, with a median of ten months. But stocks do recover. Investors with a time horizon of at least five years -- and if your horizon is shorter, you shouldn't be in the stock market -- can be confident the market will come back.


Avoid staples

What kind of stocks should you buy during a recession? Consumer-staples stocks, such as Campbell Soup and Procter & Gamble, tend not to be affected by rough patches in the economy -- which is a good reason not to buy them during a recession.

Instead, look for companies that suffer in a slowdown. Here are my ideas, and a good example of a beaten-down stock is Drew Industries (symbol DW), a maker of parts for recreational vehicles and manufactured housing.

Drew shares were clobbered in the 1990-91 and 2001 recessions, and they fell by more than half between October 2007 and mid June of 2008. The company responded to slack sales with aggressive cost-cutting, and it maintains a solid balance sheet with just $24 million in total debt. Earnings have grown at 12% annually, on average, for the past ten years. Value Line Investment Survey expects a similar rise through 2013. The stock's price-earnings ratio, based on profit forecasts for 2008, is 12.

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Research shows clearly that small companies like Drew, which has a market capitalization of $449 million, do more poorly than large companies going into a recession and much better coming out of one. According to Ned Davis Research, one year after each of the past nine recessions ended, small caps gained an average of 24%, compared with 18% for the S&P 500, which tracks large companies.

Small caps tend to be less diversified as individual businesses and more linked to the domestic economy as a whole. In addition, investors naturally fear that smaller companies, especially those undergoing a growth spurt, might sink during a tempest, while large companies have the ballast to ride out a storm.

As a result, mutual funds that focus on small, fast-growing companies have been among the hardest-hit fund categories so far in 2008. Year-to-date to June 9, small-cap growth funds were down an average of 6.5%, according to Morningstar. So in the middle of a downturn, consider buying Vanguard Small-Cap Growth Index (VISGX), a mutual fund with an expense ratio of just 0.22%, or iShares Russell 2000 Growth Index (IWO), an exchange-traded fund, which you buy or sell like a share of stock.

Also suffering in a recession are companies whose products consumers buy because they like them, rather than need them. A good example is consumer-electronics giant Sony (SNE). Sony's stock was crushed in the last two economic downturns; it has dropped only 12% since its high near the start of the year. Sony's price-to-sales ratio, a reliable forecaster of value, is just 0.6; a ratio of less than 1.0 is a possible bargain.

Another consumer-discretionary stock worth a look is General Motors (GM), whose shares have dropped 43% since early February. Or consider four technology stocks whose prices have fallen by double-digit percentages since the start of the year: Hewlett-Packard (HPQ), Intel (INTC), Microsoft (MSFT) and Verizon (VZ).

Remember the uncertainties

Can we tell if the economy is in a recession? No. And even if we could, could we tell whether the recession was still in its infancy and the stock market had more declining to do? No, again. "A recession could keep the market in retreat, but it could also lead to a great buying opportunity," says Hayes, who studies such questions for a living.

And even if we're not in a recession, the good news is that you can't go too wrong buying fine companies that have been beaten up. As the NBER reminds us: "Expansion is the normal state of the economy."