Thursday, March 12, 2009

Have We Hit Bottom Yet?

What every investor wants to know: have we hit bottom yet? Business people want to know that too. Should we lay off more people, buy that new ERP software, or cut that dividend?

Smart people will use a cover your bets approach. We have already seen a number of worst-case scenarios starting in 2007.

Typically, in the post-Depression recessions, the stock market averages started recovering before the rest of the economy. Stock markets are believed to be forward looking. But that may not be the case this time.

There are a number of differences between this recession and prior post-New Deal down cycles, and a number of similarities. Sorting them out may not tell them if we are at a bottom yet, but they can help us understand how to get our footing once there is a bottom.

Fortunately, many major corporations were cash rich going into this downturn, and are well-positioned to weather anything thrown at them short of the collapse of civilization. Some are taking advantage of their cash positions to buy assets cheap, which is what I believe investors with cash coming in should be doing right now.

Most people who are losing their jobs are getting unemployment compensation. More than any other New Deal reform, this tends to put the brakes on recessions.

The big obvious problems, of course, are banks and housing. The Federal Reserve System was set up to deal with banking credit cycle issues. Unfortunately the Fed is run by people, and in particular it was run for a long time by a certifiable idiot, Alan Greenspan. Alan drank the Free Markets are God kool-aid. If free markets were not sometimes a problem, we would not have needed the Federal Reserve in the first place. Free markets are not magic. They have their own mechanics, and don't care too much about human beings.

It is a tribute to the resiliancy of capitalism, the safety valves and safety nets of socialism that have been grafted onto it in the United States, and the good sense of most business persons that the crew of the likes of Alan Greenspan, Robert Rubin, Bill Clinton, George W. Bush, et al, actually did so little damage to our economy.

I am glad the American people, as a whole, started saving more money in 2008. Even though it hurt the holiday shopping season, even though it hurt the auction prices of some of my stocks. It was the right thing to do. Shopping on credit that has to be paid at high rates of interest is no way to run a family economic unit, and no way to run an economy. Lowered household debt as we go into 2010 will mean people will be paying less interest, and have more actual money of their own to shop with. I just hope we all remember this lesson.

Housing remains an interesting dilemma. As far as I can tell, there is no longer a surplus of housing in the U.S. as a whole, though some areas remain overbuilt, like the central California valley. If the banking system starts functioning in a healthy manner, surplus of houses for sale right now will shrink throughout 2009. In 2010 new home construction will become necessary in at least some areas. That in itself should get the economy back to normal.

But I don't feel the bottom under my feet yet. One more part of the down cycle has not really kicked in, and it could force us further out into the stormy seas. This is the bankruptcy cascade. Businesses can fall like houses of cards when this cycle starts. A business that seems solvent, with plenty of receivables to use to cover its payables, can be put in jeapardy if its receivables disappear in customer bankruptcies.

On the other hand, this is also a healthy, important part of business consolidation. Week, poorly managed businesses with insufficient profit margins or cash reserves get punished. Well-capitalized companies get a licking, for sure, but they can then pick up any paying customers of the losers and enter a new expansion cycle.

This is a stock pickers market. If you are in index funds, you are a fool. The only stocks worth buying now are those with large cash reserves built from profitable business practices. Those cash reserves stand for conservative management. They represent past profits, and they are the ticket to future profits.

Today Gilead (GILD) [I own Gilead stock] announced it will buy CV Therapeutics (CVTX). Gilead is your prototypical well-managed company. Even after it buys CV, it will have a huge cash balance. That's the way to do it.

Keep diversified!

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