It's time to face the facts. Stock picking, while always important, is not enough anymore. The recipe for making money in today's economy is a sweet blend of top-down and bottom-up analysis.
I am not the only one having this epiphany. Here's what value investing guru Seth Klarman said to investors in his 2010 annual letter:
Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macro economy altogether.
Klarman is right. Investors who ignored the subprime mortgage crisis in 2008 -- yours truly is in that bunch -- got swept up in the bear market storm surge. Sinking portfolios left many investors scared, and they missed a great opportunity when stocks rebounded.
I've learned from my mistakes and adjusted my investing strategy accordingly. This new plan to give us the best chance to protect and grow wealth is outlined in "3 Steps to Big Profits in This Crazy Market."
I've also identified a great investment opportunity using this approach that I will share with you if you're interested. But first, let's see how the economy looks right now.
It's getting better
After falling down at the end of 2008 and the beginning 2009, the U.S. economy has picked itself up, dusted itself off, and is back in the global growth race, as shown by the last six quarters of gross domestic product growth.
The consumer is now setting the pace. In the fourth quarter, consumer spending increased 4%, up from 2.4% growth in the third quarter. Spend on, American consumers!
The corporate sector continues to validate the GDP turnaround story. Companies in the S&P 500 index that have reported 2010 financial results averaged 11.5% sales growth, an incredible turnaround from the 7% contraction in 2009. The table below highlights a few companies making some dramatic improvements, either by business turning around or through a well-timed acquisition.
2010 Sales Growth
2009 Sales Growth
|MEMC Electronic Materials (NYSE: WFR )
|Frontier Communications (NYSE: FTR )
|United States Steel (NYSE: X )
Source: Capital IQ, division of Standard & Poor's.
While it was downright scary watching the economy contract and stocks plummet in 2008 and early 2009, 2010 appears to have been a great first act to the recovery story.
Some of the biggest winners in 2010 include UGG boot maker Deckers Outdoor (Nasdaq: DECK ) and supplier to the cloud-computing F5 Networks (Nasdaq: FFIV ) . I believe the high-end consumer is going to continue to spend, and Deckers is well-positioned with new styles and products to continue to grow. As for F5 Networks, cloud computing is a major wave and should continue to grow, regardless of how the economy fares.
But does accelerating GDP growth, spend-happy consumers, and rising corporate sales mean it's clear skies ahead for every stock?
Not so fast
I want to believe the recovery will persist. But I can't right now. The storm clouds of high unemployment, consumer deleveraging, and declining home prices loom eerily on the horizon. At some point, especially if the Federal Reserve raises interest rates, economic growth could slip again. So I am tempering my optimism with a bit of caution. Consider this:
The unemployment rate remains an abysmal 8.8%. The average duration of unemployment, currently about 37 weeks, has started rising again. High, drawn-out unemployment puts future GDP growth at risk, because consumer spending makes up more than 70% of GDP. And if Wal-Mart's run of same-store sales declines is any indication, a large portion of consumers continue to struggle. Future economic growth will be tough to generate if people can't get back to work.
Consumer deleveraging -- the process of reducing debts -- may be necessary in the long run, but it can also dampen our economic revival. According to the chart below, that's the trend:
Source: St. Louis Federal Reserve.
During good times, people use credit because they feel confident about repaying those debts in the future. But lost jobs and cash flow worries can rattles consumers' confidence, making "debt" a bad, bad word. Reducing debt can reduce demand and stifle economic growth.
Last but not least, housing prices, as measured by the Case-Shiller housing index, are falling again. Nearly one-quarter of residential mortgages remain underwater. And an even larger problem looms: Foreclosures are beginning to pick up again. Stress on homeowners puts more stress on the economy.
We can still make money
Although the economy is improving, it's not all clear skies ahead. The key takeaway for us is that we need to be selective in our investments. Some companies will continue to struggle because of the economy, whereas others will thrive on huge economic trends.
So we need to:
- Pay attention to the macroeconomic environment.
- Look for strong companies within strong trends.
- Be willing to trade when conditions change.
Two of the strongest companies I see today are Amazon.com (Nasdaq: AMZN ) and Google (Nasdaq: GOOG ) . From their incredible sales growth rates (40% and 24% respectively, in 2010), they are riding two strong trends: the rise of online retailing and Internet search. And both have more than enough cash on their balance sheets to not only survive but grow, even during any economic storm.
One money-making trade
If you're interested in finding out about my favorite stock today, you can read all about it for free in my new report, "3 Strong Trends, 1 Money-Making Trade." Simply click here and enter your email address in the box to let me know where you'd like me to send my top idea for making money in today's economic environment.