Last Friday was Black Friday, the unofficial kickoff date for the holiday shopping season. The early read on this year’s big shopping day is that traffic levels were relatively strong, perhaps a bit stronger than last year. However, those shoppers were lured in by some hefty discounts; it’s unclear if that traffic will translate into real sales and profits.

All indications suggest we’re in for a rough Christmas shopping season this year. As projected in this letter, the National Bureau of Economic Research (NBER) Business Cycle Dating Committee has formally declared December 2007 as the start date for the US recession.

This particular contraction has been led by consumers; Americans are firmly focused on saving and paying down debt rather than spending. The recent credit crunch has only made the consumer-led contraction worse, as buyers are finding it tough to obtain financing at attractive rates despite a bevy of interest rate cuts from the Federal Reserve.

Consumer discretionary stocks aren’t my favorites at the current time; I suspect that, unlike all recessions since the mid-1950s, the coming recovery won’t be led by a resurgence in spending by the US consumer. Rather, I’m looking for a recovery first in industrial and infrastructure stocks as well as a resurgence in demand from emerging markets like China and India. The only retailers showing any signs of strength are discounters like Wal-Mart (NYSE: WMT) and a few select specialty stores.

Although NBER doesn’t declare the end of recessions until months after they’re already over, there’s no doubt in my mind that the US is still in recession at this time. That means this recession has already lasted longer than the 11-month average for post-war contractions. Given continued deterioration in economic data, my bet is that this contraction could be the longest since the Great Depression, lasting as long, or longer, than the 1974 contraction. 

Nonetheless, despite the current gloom, it’s highly likely we’ll see the beginnings of an economic recovery at some point next year. I continue to watch a simple indicator, the US Index of Leading Economic Indicators (LEI), for any sign of a turn higher. As always, this simple indicator offers investors an early read on any signs of a turn for the better.

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And remember, the market typically leads the economy. Investors would do well to remember Warren Buffett’s statement that if you wait for the robins, spring is already over; in other words, if you wait to commit your money until after signs of an economic turn, you’ll miss a good bit of the market recovery. And with valuations as depressed across so many sectors as they are today, now marks an outstanding buying opportunity for those with longer than a six- to 12-month time frame.

My approach to this market remains unchanged: I recommend stocks, such as those in the health care industry, that offer defensive, recession-resistant growth characteristics. In addition, now’s the time to selectively buy into beaten down sectors such as energy that offer strong long-term growth characteristics and attractive valuations.

Playing Defense

In addition to the healthcare and consumer staples stocks I outlined in the last issue of PMW, bonds should form a part of every investor’s portfolio.

But don’t be sucked into the idea that bonds are inherently safe and stocks are risky. A bond is only as good as the company that issues it; bonds of companies with less-than-perfect credit have been hit hard this year.

Source: Bloomberg

The chart above shows the spread between the yield on US Treasury bonds and the yield on companies rated BBB by Standard & Poor’s (S&P). Most investors are familiar with bond ratings provided by companies like S&P and Moody’s. These ratings are meant to help investors assess the risk that a particular issuer will default on their bonds; in theory, the higher the rating, the more financially secure the firm.
 
Here’s what S&P says about BBB-rated firms on its Web site:

An obligation rated 'BBB' exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

Another way of looking at BBB-rated firms is that this is the lowest rating still considered investment grade. Firms with a rating lower than BBB are called high-yield or junk bonds.
 
As you can see from the chart above, for most of the past 20 years, 10-year corporate bonds rated BBB have offered a yield roughly 1.25 to 2.25 percent higher than US Treasuries of a similar maturity. One useful way to think of this spread is that it’s a sort of risk premium: The higher the spread, the higher the return investors are demanding to accept the risk of holding BBB-rated bonds rather than risk-free Treasuries.

It’s obvious what’s happened over the past six months; yield spreads have exploded to unprecedented levels of around 5 percent. That’s more than double the average level of the 1990 through 2007 period.

As any bond investor knows, bond prices move inversely with yields. This spike in the yield spread spells a huge decline in price for the BBB-rated bonds. In many cases, the value of these bonds has declined as much or more than the broad US stock averages.

There are two clear implications of this trend. First, investors owning bonds would do well to carefully assess the credit of the bonds they own; do not assume that bonds are inherently risk-free. Income-oriented investors shouldn’t be tempted to simply snap up bonds that offer the highest-yields.

Second, all high-yield bonds and low-grade investment credits have been slaughtered this year. That means there are definitely values to be found in this market.

In the last issue of The Energy Strategist, I recommend a bond issued by gas-focused producer Chesapeake Energy (NYSE: CHK) that offers a double-digit yield. And although Chesapeake carries significant debt, the company has solid, dependable cash flows thanks to its low cost of production and hedges that allow it to sell gas at prices significantly higher than the current quote.

Finally, Chesapeake has the strongest position in the US unconventional reserves of any producer; the company has been able to monetize these assets by selling a partial stake in some of its most promising plays to raise cash.

Gas Over Oil

On the energy front, I continue to favor companies leveraged to natural gas over those with heavy exposure to crude oil. Ironically, gas prices will ultimately benefit from the ongoing credit crunch.


Source: Bloomberg

This chart shows the US active rig count published by Baker Hughes (NYSE: BHI) each week. This is, quite literally, a measure of how many rigs are currently actively drilling for oil or natural gas in the US.

As you can see, the rig count has dropped precipitously in recent weeks. In fact, last week’s dropoff of 75 in the rig count is the largest single weekly decline in the history of the index.

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The rig count is a raw measure of drilling activity. It’s dropping for two main reasons: The credit crunch is affecting the ability of smaller producers to drill, and low gas prices are prompting many producers to lay off rigs.

The current price for natural gas on the New York Mercantile Exchange (NYMEX) is around $6.50 to $7.00 per million British thermal units (MMBtu). At these prices, some drillers are still profitable, particularly in some of the prolific shale plays. But natural gas trades at different prices in different parts of the US thanks to pipeline and storage constraints; at the current time prices in the Rockies and parts of Oklahoma are under $4 per MMBtu. At those prices, most producers simply aren’t profitable. They’re cutting back on their drilling plans and idling rigs.

Add to that the effect of the credit crunch. More than half of US gas producers are small firms with a handful of wells. Many fund their operations partly with debt capital. But that debt financing is drying up for most companies, especially smaller producers. To cope, they’re paring back their operations and to live within their free cash flow. The result: a rapid dropoff in rigs count, particularly for basic, low-power rigs.

The ultimate effect of this decline in activity is lower gas supply. Many US natural gas wells have a decline rate of 30 to 50 percent; in the first year of production, the output from the well declines by between a third and a half. Therefore if producers stop drilling new wells, production quickly falls sharply.

When you couple the drop in supply with current predictions for the coldest winter in a decade, you have the recipe for higher natural gas prices and a major drawdown of natural gas in storage.