The Most Dangerous Way to Invest Today

The panic-filled market of the past year taught or reminded investors of many important lessons, including the importance of diversification, investing only in companies whose business you can understand, and that "cash ain't trash" after all.

Another lesson that must be heeded is that "bottom up" research is a downright dangerous way to invest. To review, "bottom up" research looks at businesses first and de-emphasizes macroeconomic factors. If this market has taught us anything, however, it's that ignoring the economy can have dire consequences.

No fa-fa-fa-Foolin'
Picking a stock without considering the economic environment is like picking out your clothes in the morning without considering the weather that day. Sure, that Def Leppard 1987 Hysteria Tour T-shirt may be comfortable and give you tons of street cred, but it's just not practical in a foot of snow.

All joking aside, no matter what sector you're looking at, there are macroeconomic factors that will make a big difference to your investing thesis -- durable-goods orders if you're looking at manufacturers, housing starts for homebuilders.

Right now, for example, companies dependent on consumer spending are facing some serious headwinds:

  • The American labor force is weakening. As of May 2009,  14.5 million Americans were unemployed -- a record high. Unemployment sits at 9.4%. If you include involuntary part-time workers and those who've given up looking for work, the so-called "underemployed," that figure spikes to 16.4%. In other words, nearly one-sixth of the American workforce is not contributing its full potential to the economy. These figures could get higher, because they haven't even taken into account the large layoffs recently announced by American Express (NYSE: AXP  ) , Boeing (NYSE: BA  ) , and Medtronic (NYSE: MDT  ) . 
  • Consumer credit is drying up. To compound the problem of unemployment, credit card issuers like Capital One Financial (NYSE: COF  ) and JPMorgan Chase (NYSE: JPM  ) become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. You can't really blame them for being concerned about borrower solvency, either. Credit card defaults reached record highs in April, and increasing regulation from Washington could put a crimp on issuers' profits. The combination of less available credit and less income from employment will inevitably lead to less spending, particularly on big-ticket items.

  • Baby boomers were walloped by this economy. This economy couldn't have come at a worse time for the 78 million or so baby boomers approaching or already in retirement. A recent study done by David Rosnick and Dean Baker of the Center for Economic and Policy Research discusses the adverse effects of the market crash on baby boomers' wealth and found that "The median household with a person between the ages of 45 to 54 saw its net worth fall by more than 45 percent between 2004 and 2009. ... The median household with a person between the ages of 55 and 64 saw its wealth fall by almost 50 percent." Enough said.

This new reality is significant on many levels, but the biggest consequence of a poorer boomer generation may be found in the retail sector. The boomer demographic accounts for about 40% of total consumer spending (about $3.8 trillion annually). Since consumer spending makes up 70% of our GDP, you can see how much a suddenly stingy boomer generation can hurt our economy.

Less boomer spending would hurt retailers across the board, but particularly those that sell highly discretionary, nonessential items, like Blue Nile and Carnival (NYSE: CCL  ) .

Where we're left
Despite these mounting economic woes, there are still stocks worth buying in this market. But the research process must begin with a macroeconomic analysis, followed by a thorough vetting of businesses.

Since we launched our Motley Fool Pro service in October, we've taken the plight of the U.S. consumer very seriously, focusing our research on companies that produce goods and services that people need, versus what they want. For example, we'd be much more inclined to research a stock like Johnson & Johnson (NYSE: JNJ  ) versus a beaten-down retailer like Abercrombie & Fitch. Consumers can do without $100 blue jeans, but they are much less likely to do without things like Band-Aids, Sudafed, and Tylenol.

Even though Abercrombie may look like a value at the moment from a bottom-up approach, it could be an even better value six months or a year from now. After all, even value is vulnerable without a catalyst to unlock it, and there appears to be no economic catalyst in sight for high-end consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for it to rebound.

At Pro, we're interested only in buying undervalued stocks with both strong fundamentals and positive economic support. Our top priority is accuracy, and we have a goal of generating positive returns with at least 75% of our investments. This means we must not only be selective with the investments we make, but also fully consider the economic environments in which they operate.

If you'd like to learn more about our Pro strategy, please enter your email address below.

This article was originally published on Dec. 19, 2008. It has been updated.

Pro analyst Todd Wenning pours some sugar in his afternoon coffee, in the name of love. He does not own shares of any company mentioned. Blue Nile is a Motley Fool Rule Breakers selection. American Express is an Inside Value recommendation, and The Fool owns shares of it. Johnson & Johnson is an Income Investor pick. The Fool is investors writing for investors.


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