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Beware the Second Leg of the Next Great Recession

There's no doubt that there are green shoots in the economy. The housing market, which brought on the crash, may finally be starting to recover. Housing stats bottomed in January 2009, and it looks like the rate of decline of housing prices is slowing. Charge-offs are increasing at a lower rate at US Bank (NYSE: USB  ) , while Bank of America (NYSE: BAC  ) reports that its credit quality appears to be stabilizing. And corporate earnings aren't as big a disaster as everyone thought they'd be.

But now is not the time to be complacent.

Delusions of grandeur
Unfortunately, there's been very little evidence of a solid recovery. Sure, the financial crisis seems to be past, and the economy didn't collapse. After the turmoil that followed Lehman's failure, the government's quick actions to shore up the financial sector have convinced people that it won't let another big bank fail. Consequently, the sheer terror we experienced last fall has faded to mere paranoia.

But beyond that, it's unclear when the real economy will recover. America's gross domestic product (GDP) was plummeting, and it now seems to be flattening out, but that isn't a great indicator of a recovery. It's almost inevitable that without a complete financial collapse, GDP won't keep shrinking for long. A big part of the decline in GDP has been owed to inventories, which had been plummeting since October 2008. But manufacturers eventually have to increase output or they'll run out of widgets to sell, and that boosts GDP figures.

What's more, the government has been throwing money at the economy to try to reverse the vicious cycle of layoffs resulting in lower corporate sales, which in turn lead to more layoffs. This, too, props up GDP, so it's not really surprising that GDP seems to have bottomed.

The key to recovery
But funding a recovery with huge government spending and massive debt is like using a defibrillator to treat a heart attack. It can work well in short doses, but it's completely unsustainable over the long term. Maybe General Motors, Ford, and Toyota aren't complaining about the 30% boost to car sales in August as a result of the Cash for Clunkers program. But does anyone really believe that demand will be sustained?

The government isn't the key to recovery. Neither are corporations. Consumer spending is what really matters, accounting for 70% of GDP. But right now, consumers are acting as cheap as a congressman who has to spend his own money.

Americans seem to have finally realized that taking on a third mortgage to buy a second 74-inch TV for the bathroom is not a sensible decision. Household debt, which has been steadily rising since the 1950s, has actually started to decline. And consumer confidence, while improving, only looks good when you compare it to the all-time lows it hit last February.

But why should consumers be confident? The unemployment rate stands at 10%. As if that weren't bad enough, when you include the number of underemployed workers, that figure rises to 17.3%.

And you expect consumers to help the economy rebound? Good luck with that.

Mixed messages
Insiders are nervous. According to TrimTabs, the ratio of insider selling to buying in August exceeded 30, the highest level since TrimTabs started measuring the statistic in 2004, and it remains quite high.

Companies as diverse as Wynn Resorts (Nasdaq: WYNN  ) , Wal-Mart (NYSE: WMT  ) , Harley Davisdon (NYSE: HOG  ) , Monsanto (NYSE: MON  ) , and Yum! Brands (NYSE: YUM  ) participated in the recent spate of insider selling.

But despite all these problems, it's still hard to form a firm conclusion. Employment is a lagging indicator -- companies hire when they need workers, not because they think that there's a chance they'll need workers next year. And insiders, like other investors, may simply be taking advantage of the huge bounce since March. Maybe we just need to wait, and those green shoots will blossom. If everything looked bright and cheery, it would hardly be the Great Recession, now would it?

It's a very confusing environment in which to be an investor. If this is the start of a recovery, the market could still run another 30% before testing the old highs. So scaling back your portfolio doesn't make sense. But if this is just an economic head-fake, do you really want to relive the last few months of 2008?

The solution is to focus on value stocks. Value investing really shines right now, because it provides the best of both worlds. If you can buy a stock for 50% of its fair value, you make a 100% return if the stock returns to more rational pricing. But since stocks tend to gravitate toward a fair price, value stocks can also cushion your portfolio during a bear market. You can get the upside, with less downside risk.

The Foolish bottom line
Our Inside Value newsletter has illustrated these benefits nicely. Since 2004 -- including the massive plunge between last September and March -- this newsletter's recommendations outperformed the market by more than seven percentage points per pick.

That combination of excellent upside with a reduced downside is what makes value stocks so compelling right now. If you'd like to read about our top picks, we're offering a free trial of Inside Value.

This article was originally published Sept. 11, 2009. It has been updated.

Fool contributor Richard Gibbons collects things that gravitate. Monsanto and Wal-Mart Stores are Motley Fool Inside Value recommendations. Ford Motor is a Stock Advisor choice. The Fool's disclosure policy will rock you like a hurricane.

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