Can Your Portfolio Survive a Recession?

I have a graduate degree in economics, which probably means I know very little about anything. Thank goodness that I have another one in journalism, so I'm unabashed about translating my lack of knowledge into opinions on almost everything.

Nevertheless, much as I hate to offer the conclusion that our economy might just be moving headlong into a recession -- however slight and temporary -- there's a certain scent out there that, to my way of thinking, is unmistakable. Indeed, I've been perplexed for a while now by how we could continue to avoid the ill effects of increasing oil prices, and with them the more direct pain at the pump, and continue to ride a vibrant economy.

Add to that the sudden discovery by mortgage lenders and originators that it'd be nice to have at least some information about a borrower's employment status and income -- a somewhat strange notion that has spread upward to typically more sophisticated areas of lending -- and I'm frankly at a loss to imagine how we can avoid a slowing in the growth rate of our gross domestic product.

Watch the consumer ...
Of course, the consumer is one of the keys to the likelihood -- or lack thereof -- that we'll slip on an economic banana peel. You'll recall from the first day of Econ 101 that about two-thirds of that gross domestic product that we're so concerned about is tied to consumer spending. The rest is divided among government spending, business investment, and net exports.

Depending on who you listen to, the consumer is either blowing and going or beginning to tire. My current reading is starting to lean slightly toward the latter. While some retailers in the last reporting period came up with solid results -- Lowe's (NYSE: LOW  ) and Dick's Sporting Goods (NYSE: DKS  ) come to mind -- others such as Gap (NYSE: GPS  ) and Best Buy (NYSE: BBY  ) were more mixed. All in all, I'd say the jury appears to remain out on whether the biggest sector of the economy can remain strong.

Or at least, it probably was until Friday, when the markets became petrified to the tune of 250 downside points in the Dow due to a Labor Department report that payrolls fell by 4,000 in August. That wasn't much of a slip, perhaps -- and the unemployment rate did hold in there at 4.6% -- but it was the first drop in four years. Combine it with a global crude price that's marched steadily upward this year and a still worsening housing sector, and it appears that we'll be fortunate to avoid an accelerating drop in consumer confidence and spending.

... and housing
Ah yes, the housing sector. Before the market's minions were unsettled by the Friday jobs report, on the previous day came the information that the foreclosure notices for homeowners set a record in the spring quarter. According to the Mortgage Bankers Association, between April and June, 0.65% of all home loans became slated for foreclosures. The group attributed the rise -- the third consecutive quarterly increase -- to both job losses in the Midwest, as manufacturing continues to move overseas, and the plummeting housing markets in California, Florida, Nevada, and Arizona.

The difficulty with the latest foreclosure metrics is one of timing. The June quarter could only begin to reflect the effects of increasing resets to subprime mortgages. As many as 2 million of these are expected to move to higher interest rates -- and monthly payments -- by the end of 2008. Since September, December, and the four periods of 2008 will involve far more resets, many on homes whose values have fallen, we may just be getting started with our foreclosure numbers.

At the same time, with mortgages becoming harder to come by for first-time buyers, those with soiled credit, and those looking for jumbo financing, it's easy to see how the bottom for the homebuilders may still be off in the distance. Indeed, when he released his company's July results Thursday, Hovnanian (NYSE: HOV  ) CEO Ara Hovnanian discussed the increasing effects of tighter lending standards on his company after the quarter closed.

Gawking at the Fed
So now, with our admittedly mixed picture, all eyes have turned to the Federal Reserve and the potential for a Fed funds rate cut at next week's meeting. I'll be able to utter the economist's favorite line, "On the other hand," if I remind you that there clearly are two distinct schools of thought as we look at the Fed's options.

First, there is the reality of increasing credit tightness, the resulting drop in liquidity, and now a possibly declining jobs picture. But -- and here I go -- on the other hand, there are those who would question the wisdom of effectively reducing the value of our currency in a time of worldwide commodities price inflation. In the latter area, not only energy prices, but the costs of a host of other necessities for our global economy have ratcheted up steadily of late.

Your guess is as good as mine regarding the likelihood that the Fed will drop the funds rate, say, 25 basis points. In fact, if you don't have an economics degree, your opinion just might be better than mine. But either way, what we do know is that the market is extremely skittish, and Fools would be well advised to take steps to insulate themselves from the all-too-frequent triple-digit swings that have recently characterized the equities markets.

Good sectors and bad
So whether we're headed for a recession and whether or not the Fed begins to chip away at short rates, I think the very financial uncertainty in which we're operating makes careful sector selection more important than ever for our investment allocations. For instance, as I've said before, the homebuilders should be verboten for a while for Foolish portfolios. And since we don't know how long or severe our credit crunch will be, I'd be inclined to shy away from financial stocks, and I'd similarly exercise caution for a while with the retailers.  

My preferences lean to the top three S&P sectors during the second quarter of this year: energy, technology, and industrials. But in the interest of not throwing too much at you at once, let me just mention the approach I'd recommend to less-than-experienced energy investors. Quite simply, I'd suggest that you begin with the biggest players in the exploration and production and oilfield services areas, respectively -- ExxonMobil (NYSE: XOM  ) and Schlumberger (NYSE: SLB  ) . After that, you can add a blend of quality producers and solid services names -- especially those with significant international exposure.

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David Smith

A longtime securities analyst and multiple-term member of The Wall Street Journal's All-Star Research team, Dave specializes in energy and natural resources.

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