Cash in on the Recovery

A glimmer of hope for the economy translates into big gains for stocks. It's not too late to buy.

The U.S. remains mired in what will likely enter the history books as the longest and deepest recession since the Great Depression. But there are signs the cycle is turning. Prices for economically sensitive commodities, such as copper and oil, have bottomed. Credit markets are returning to life. Businesses have slashed inventories, which will eventually have to be restocked. Confidence among consumers and business executives is rebounding from extremely depressed levels. The rate of decline in housing prices appears to be slowing.

The strongest hint of change may be coming from the stock market. From its March 9 close through May 8, Standard & Poor's 500-stock index soared 37%. Skeptics say the rousing rebound is nothing more than a bear-market rally. But it's hard to ignore an advance of such magnitude, especially when combined with solid indications that an economic bottom is at hand (for a look at some key signs, see How to Spot the Bottom). "A few months ago people worried about the survivability of the financial system," says William Greiner, chief investment officer of UMB Asset Management. "Now they focus on when the recession will end."

After plunging 25% in the opening ten weeks of 2009, the market was flat for the year as of May 8. We still think there is a good chance that U.S. stocks will finish '09 with a gain of 5% to 8%, as we predicted in our January Outlook 2009 story. The Dow Jones industrial average, which closed at 8575 on May 8, could hit 9500 during 2009. That would be welcome relief from a harrowing 17-month-long bear market that pummeled stocks by 55%.

In many ways, the U.S. government contributed to the made-in-America financial crisis. It did so through excessively lax monetary policy, irresponsible promotion of a reckless subprime-mortgage industry, and a failure to properly regulate banks and other financial institutions. But give Uncle Sam his due for preventing a financial collapse that could have resulted in the economy falling into an abyss. "If the government did anything right, it was able, through a series of actions, to keep people from ultimate panic," says David Ellison, chief investment officer for the FBR Equity funds.

Greiner thinks President Barack Obama's administration deserves credit for restoring stability by pushing through the stimulus bill and coming up with plans to cleanse the clogged arteries of the banking system. Although it will take time before the country feels the full effect of stimulus spending, the impact of such Obama policies as tax credits for first-time home buyers is helping to support the foundering housing industry. The stress test for banks, which resulted in a call for ten companies to raise capital, provided investors with some clarity about the industry's health. Of course, the Federal Reserve, which has essentially slashed short-term interest rates to zero and taken other actions to stimulate the economy and keep the banking system functioning, deserves credit as well.

Confidence factor

Ron Rimkus, senior vice-president of BB&T Asset Management, describes a struggle between powerful deflationary forces met by a huge response from government. Only recently has Rimkus started to believe that the government is finally winning the battle to reignite the economy.

And don't underestimate the role of confidence-building. Through his popularity, credibility and frequent public appearances, President Obama has helped a shaken population start to regain faith in the economy.

Regardless of whether Obama, by deed or word, helps end the recession, investors aren't waiting for official confirmation that the downturn is over. By returning in force to stocks and risky fixed-income investments, such as junk bonds, they clearly anticipate better times ahead, including a recovery by the end of this year. "Being a leading indicator, stocks can't wait for earnings and other economic indicators to be good," says Duncan Richardson, head of stock investments at the Eaton Vance funds.

Because of the March-May run-up, stocks are no longer the bargains they were in the depths of the bear market. As of May 8, the S&P 500 traded at a not-so-cheap 17 times projected operating earnings for 2009. Still, stocks will continue to climb if the economy does begin to grow later this year, helping to boost corporate earnings, which have been cut in half since peaking in 2007.

One bright spot is that interest rates are so low that cash and Treasury bonds offer little competition for stocks. Shellshocked savers have squirreled away close to $4 trillion in low-yielding money-market funds, savings that could flow into stocks if investors' confidence and appetite for risk continue to improve (for the fixed-income outlook, see Bargains Still Abound in Bonds).

Reasonable energy prices and record-low mortgage rates, as well as government spending, will aid beleaguered Americans. Richardson estimates that consumers will have an extra $500 billion in cash, thanks to the drop in energy prices and a new refinancing boom precipitated by declines in mortgage rates.

The outlook beyond 2009 is murkier. The trouble is that the economic recovery will likely be an anemic one -- with annual growth of perhaps 1% to 2% rather than the 4% to 5% that is normal when recovering from a recession -- to be followed by an extended period of subdued growth.

Why? For one thing, consumer spending, which represents 70% of the economy, is under stress. Joseph Davis, chief economist for the Vanguard funds, notes that U.S. households have suffered a colossal decline in net worth. In the 18-month period through March 2009, says Davis, $15 trillion in wealth vanished as a result of collapsing home and stock prices. That's equal to more than a year's gross domestic product and enough to depress spending by $750 billion over two years, he projects.

As bad as things are at home, they're even worse abroad in countries such as Japan, Great Britain and Spain. The global economy will shrink this year for the first time since World War II. "This is the most synchronized global recession we've seen -- we're all in this one together," says David Wyss, chief economist for Standard & Poor's. So we can't expect much stimulus from our exports (see China: A Bright Spot Overseas for the outlook for foreign stocks).

That's a recipe for a modest, uneven recovery in earnings over the next 12 to 18 months. Remember that earnings came off an unnaturally elevated level when the dam broke in 2007. Ben Inker, director of asset allocation for GMO, a Boston money manager, says that coming into this recession, operating profit margins were 8%, the highest on record (the historic norm is 6%), because the economy was pumped up by massive leverage in the financial and household sectors.

Mark Kiesel, global head of Pimco's corporate-bond management group, says U.S. consumers are in the midst of deleveraging (paying down debts), which will require several years. Indebtedness has soared over the past 20 years, reaching the point that Americans spent virtually all of their income. The roof fell in when the housing and credit markets collapsed. As people learn -- and are forced -- to live within their means, the household savings rate will climb back from zero toward the historic norm of 8%, says Kiesel.

David Kelly, chief market strategist for J.P. Morgan Asset Management, foresees a dichotomy in generational habits. He predicts that young Americans will revert to free-spending consumer behavior, while Americans 55 and older who have seen their 401(k)s decimated "will hunker down and spend frugally, permanently increasing their savings."

The portion of the economy linked to consumer spending -- 70% in recent years -- will decline to 65% to 66% as Americans rebuild savings. "We have to get to a point where consumption is sustainable, which requires a higher level of savings," says FBR's Ellison. "The American dream is still there, but we've tried to borrow it instead of earn it."

The steady rise of leverage and consumption fueled economic growth, including corporate earnings, over the past decade. Now the economy will pay a price as it works off years of unsustainable excess. Economists such as Vanguard's Davis think the forces of deleveraging and financial restructuring are profound enough to knock a percentage point off the economy's historical growth rate, to 2% to 2.5% over the next three to five years.

The other great weight on the economy -- directly related to years of excess consumption and leverage -- is the nation's enfeebled financial system. Banks are aggressively shrinking their balance sheets and, with the aid of the government's checkbook, are trying to purge bad assets. Under any scenario, it will take at least two to three years for the financial sector to heal itself from deep, self-inflicted wounds.

The heart of the mess is the housing collapse. Housing prices have plunged an average of 30% since they peaked in mid 2006. Analysts think residential prices will fall another 10% or so before bottoming out in 2010.

Banks can earn good profits today because of the wide gap between what they pay on deposits and what they earn making loans. But for banks to become healthy and willing to lend, asset prices need to stabilize, and bad loans and securities must be purged from their balance sheets. We haven't gotten to that point yet.

In the first quarter of 2009, banks foreclosed on 800,000 homes -- a record -- and another 3.2 million mortgages were seriously delinquent. Those numbers continue to mount. Economist and fund manager John Hussman says that interest-rate resets -- often the trigger for loan defaults and foreclosures -- have peaked for subprime mortgages. But Hussman warns that resets on a slew of other nontraditional mortgages, such as no-documentation loans, that originated late in the housing bubble will spike this year and will accelerate in 2010 and 2011. He expects these resets to trigger another wave of foreclosures.

Staggering losses

To the mountain of bad mortgages, which have eviscerated banks' equity capital, you can add mounting write-downs from bad commercial real estate mortgages, credit cards and other loans. The International Monetary Fund projects that when all is said and done, the U.S. financial system will suffer a staggering $2.7 trillion in write-downs from dud credit. Throughout history, economic recoveries on the heels of large bank crises tend to be slow and halting.

But assuming that a modest economic recovery is taking root, the investment landscape starts to change shape. For stock investors, it makes sense to migrate from defensive industries, such as health care and food, into economically sensitive sectors, such as technology, retail, energy and finance (yes, finance).

Eaton Vance's Richardson says he views potential winners and losers almost in terms of a Darwinian survival of the fittest. He doesn't want to hold shares of companies that need to roll over debt and rely on balky capital markets to fund themselves because they may have trouble staying afloat. The survivors, he says, will be industry leaders with strong balance sheets and cash flows. So in retailing, for example, he likes Best Buy (symbol BBY) and Staples (SPLS).

Alan Gayle, a strategist at RidgeWorth Capital Management, likes technology companies with low debt, strong cash flows and high, sustainable profit margins. Two of his favorites are Google (GOOG), which will gain from a recovery in advertising, and Accenture (ACN), a more defensive play that benefits from high renewal rates for technology-consulting contracts.

After last year's boom and bust in commodity prices, many fund managers are warming again to natural resources, especially oil and gold. Global demand for oil will actually contract this year -- a rare event. But producing wells are in decline, investment in exploration and production has been depressed, and supply is constrained.

Tim Guinness, manager of Guinness Atkinson Global Energy, thinks the price of oil, $58 a barrel in early May, will average $60 in 2010 and $70 in 2011. Even these fairly modest increases are bullish for oil stocks, many of which are well below their highs. Among the stocks he likes are ConocoPhillips (COP) and Marathon Oil (MRO).

The case for gold relates to policies of the Fed and central banks around the globe. "Governments are printing money like crazy, which will be very difficult to unwind in a timely, harmless way," says BB&T's Rimkus.

Inflation is unlikely to be a problem in 2009 or 2010 because of high unemployment and slack capacity in factories and real estate. But because they fear potential inflation down the road, some fund managers are allocating 3% to 5% of their portfolios -- sometimes more -- to gold and gold-mining stocks. Rimkus invests in gold bullion through SPDR Gold Shares (GLD), an exchange-traded fund that tracks the metal's price, as well as shares of miners, such as Barrick Gold (ABX).

Case for financials

FBR's Ellison thinks this is a fine time to invest in banks. Ellison, who runs two financial-sector funds for FBR, says that the best time to make money in the group is "when operating conditions are going from ugly to okay, not from good to great." Among his holdings are JPMorgan (JPM), Wells Fargo (WFC), PNC Financial Services (PNC) and First Niagara Financial Group (FNFG). (For a look at banks that have stayed out of trouble, see The Little Bank That Made Good.)

You can tap into any of these investment themes and strategies through no-load mutual funds. Drawing from the Kiplinger 25, two large-company growth funds we like are Fidelity Contrafund (FCNTX) and Vanguard Primecap Core (VPCCX). Longleaf Partners (LLPFX), a value-oriented fund, has rebounded smartly this year (see How We Pick Funds and What a Difference a Couple of Torrid Months Make for more on the Kiplinger 25). In the midsize-company camp, T. Rowe Price Mid-Cap Growth (RPMGX) is also putting up fine numbers. If you want exposure to small growth companies, consider Baron Small Cap (BSCFX) and FBR Focus (FBRVX).

For more-conservative investors, FPA Crescent (FPACX), a fund that invests in both stocks and bonds, has a good record of protecting capital in any market environment. Two good choices for riding a recovery in commodity prices are T. Rowe Price New Era (PRNEX) and Vanguard Energy (VGENX).

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