Are We Headed for a Recession? Who Cares?

Investor beware? Learn all about a down market with our recession survival guide.

Is the United States headed for a recession? Yale professor Robert Shiller certainly thinks so. In a recent interview, Shiller told The Times that the American real estate sector has "trillions of dollars' worth of losses" yet to come, and it could plunge the U.S. into a "Japan-style slump."

But don't tell that to U.S. Treasury Secretary Henry Paulson. Although Paulson admits the economic outlook is challenging, he feels that "the economy and the markets are strong enough to absorb" rising credit losses, and he remains confident that rate cuts and rebates will ward off a recession.

Then there's financial newsletter tracker Mark Hulbert, who concluded that "the odds had increased that we were already in a recession" -- and he wrote that in September!

The three wise men
When three experts offer three different opinions, it's difficult to know whom to trust. So here's my advice: Ignore them all.

Seriously, ignore them all
Suppose Shiller's correct, and the U.S. is headed for a recession. Or maybe Hulbert has it right, and we've been in a recession for months. Does it ultimately matter? Should you alter your stock selection process? Should you sell off your stock holdings in favor of government bonds?

Just what the heck is a recession, and what does it mean for stocks? The answers may surprise you.

What goes up must come down
A recession is the period between a peak of economic activity and a trough. Recessions typically last between six and 18 months, and they're a perfectly natural part of the business cycle.

To determine whether the economy is in recession, the National Bureau of Economic Research (NBER) analyzes changes in factors such as gross domestic product, personal income, employment, industrial production, and retail sales volume. There is no fixed rule for how the different indicators are weighed.

But there is a significant delay
It takes time for the NBER to collect and analyze this economic data. By the time it's determined that the country is in a recession, odds are that the economy is already close to recovering. For example, the last trough in economic activity occurred in November 2001 -- but the NBER didn't make that determination until July 2003. By that time, the economy had been improving for more than a year and a half!

Wait, stocks can go up in a recession?
Since 1945, there have been 11 recessions lasting an average of 10 months each. But according to a recent article from Hulbert, during these recessions, the stock market actually rose seven times -- and the average market return during all 11 recessions was 3%!

Those who ignore the past ...
During the 2001 recession, the S&P 500 fell about 12%. However, this was largely because of  the abysmal performance of a few technology companies:

Meanwhile, quality companies with strong balance sheets, solid free cash flow, and shareholder-friendly management actually prospered during this period:

Heads you win, tails you still win
Here's how to silence the noise: Concentrate on finding the types of stocks that will perform well in any economic environment. At our Motley Fool Stock Advisor investing service, Fool co-founders David and Tom Gardner advise investors not to try to time the market or forecast the next recession.

Rather, they suggest that you only invest in quality companies with strong balance sheets, solid free cash flow, and shareholder-friendly management. And fortunately, thanks to fears of an impending economic slowdown, many quality companies are available on the cheap.

Consider Stock Advisor pick Dolby Laboratories (NYSE: DLB), currently down 33% from its 52-week high. Dolby's innovative audio technology is responsible for enhancing sound quality in virtually all DVD players and a growing number of digital televisions, PCs, video game consoles, cell phones, and cinemas. The company has tripled its revenue over the past five years, and the bottom line has grown at an even greater pace due to the magic of expanding margins.

An analyst downgrade and anticipation of weakened consumer demand for PCs and consumer electronics have sent shares spiraling, but investors have little cause for concern. A temporary slowdown in the U.S. economy may affect Dolby's earnings somewhat in the near term. But the company is poised to benefit as consumers inevitably upgrade to the next generation of media devices.

Meanwhile, Dolby is branching out into the mobile, digital broadcast, and internet markets, and it's establishing a dominant position in the new arena of digital cinema. The company has $480 million in cash versus just $11 million in debt, and it's led by passionate, experienced management with a significant ownership stake.

If the U.S. economy does enter a recession, chances are pretty good that Dolby will survive. However, thanks to the market's irrational fear, today you can scoop up shares of this quality company at a discount to intrinsic value.

All quality, all the time
So far, the Stock Advisor strategy has paid off: David and Tom's average recommendation is up 54%, versus 17% for like amounts invested in the S&P 500. To see all of David and Tom's recommendations and to browse through their complete archives, click here for a free 30-day trial. There is no obligation to subscribe.

This article was first published Jan. 11, 2008. It has been updated.

The only recession that concerns Rich Greifner is that of his hairline. Rich does not own shares in any company mentioned in this article. Best Buy and Dolby are Stock Advisor recommendations. Best Buy is also an Inside Value recommendation. The Fool has a disclosure policy.