The Most Dangerous Way to Invest Today

The Most Dangerous Way to Invest Today
By Todd Wenning December 19, 2008 Comments (7)

This market panic has 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.
In the last three months, the economy has shed 1.25 million jobs. Unemployment currently sits at 6.7%. Add that figure to the 12.5% underemployment rate (part-time workers who want to work full-time), and you have nearly 20% of the American workforce not contributing its full potential to the economy. These figures could get higher, since they haven't even taken into account the massive layoffs recently announced by Bank of America (NYSE: BAC), 3M (NYSE: MMM), and Dow Chemical (NYSE: DOW).

Consumer credit is drying up.
To compound the problem of unemployment, credit card companies like American Express (NYSE: AXP) and Capital One Financial (NYSE: COF) have become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. With 60-plus-day delinquencies up some 24% since August, it's hard to blame them for these moves. But the combination of less available credit and less income from employment will inevitably lead to less spending.

Baby boomers are being 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. According to Fidelity, at the end of 2007, its 401(k) participants aged 60 to 64 held a median 66% of their portfolios in equities. Given that the S&P 500 is down 38% year-to-date, it's reasonable to assume that the median boomer 401(k) lost about 25%-30% of its value this year. Besides the stock market losses, an estimated $4.5 trillion of wealth has been wiped out as a result of the real estate market crash of the past two years.
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.
If boomers cut just 10% of their $3.8 trillion in annual spending this year, it could set GDP back some 3%. Less boomer spending would negatively affect retailers across the board, from women's clothiers like Ann Taylor (NYSE: ANN) to casual-dining restaurants like Darden Restaurants' Red Lobster and Olive Garden.

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 consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for retail to rebound.
At Pro, we're only interested 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.

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. Johnson & Johnson, Dow Chemical, and Bank of America are Motley Fool Income Investor recommendations. 3M and American Express are Motley Fool Inside Value picks. The Fool owns shares of American Express. The Fool is investors writing for investors.