5 stocks for even-gloomier times

By Jim Jubak

From an investor's point of view, bad news doesn't count if it's already priced into the markets. If the financial markets already anticipate the end of the world, news that the comet of doom has been spotted clearing Pluto's orbit is, well, no big deal.

It's unanticipated bad news that knocks an individual stock or the market as a whole for a loop.

That's why the Congressional Budget Office's Jan. 8 report on the state of the nation's finances was such bad news for investors.

It was depressing, of course. There's no way around it: Any report on the current state of the financial world will contain enough horror to revive the "Texas Chainsaw Massacre" blood-fest franchise. It's "Scream" without the jokes. Most of this bad news, though, is already priced into the financial markets. To investors who haven't voluntarily decided to pull the blankets over their heads until the crisis is over, it wasn't earth-shaking. We know it's a disaster. So what?

They weren't expecting this

But there was unanticipated bad news in the report. The budget office projects we won't see a full economic recovery until 2015 and that even then it will be weaker than expected. That's not priced into the markets.

Stock prices currently vacillate between optimism that the bad times will be over within six months and pessimism that they'll last well into 2010. Prices certainly don't reflect a belief in a weak recovery that leaves growth at just 2.3% by 2015. The budget office projection, if it turns out to be correct, is the kind of unanticipated news that can and would knock stocks for a loop.

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So what do you do? It's especially tough to design a strategy now to cope with something that's only a projection -- and a projection for 2015 at that. But let me suggest a way to think about this projection and to judge its reasonableness, and then give you an investment strategy and five stocks that will provide a good hedge on that projection if it's correct but not leave you gasping for profits if it's wrong.

What did the Congressional Budget Office say?

• It projects the U.S. budget deficit will come to just about $1.2 trillion in fiscal 2009, which ends this September. That's $1.2 trillion before including any of President-elect Barack Obama's projected $700 billion to $800 billion stimulus package.

• Including the costs of the proposed stimulus package, the fiscal 2009 deficit climbs to almost 10% of U.S. gross domestic product, shattering the nation's post-World War II record (6% in 1983) for a deficit as a percentage of the economy.

• The total U.S. government debt held by the public will jump 55% from September 2007 to September 2010.

• Without a big stimulus package, the economy will shrink 2.2% in fiscal 2009, unemployment will peak at 9.2% in 2010, and housing prices will fall an additional 14%.

• And, finally, the U.S. economy won't return to its full annual trend growth rate until 2015. Worst yet, that trend growth rate for the U.S. economy will be just 2.3% a year.

It's that last item that constitutes unanticipated bad news. That projected schedule for a recovery lags well behind the already gloomy timeline from the Federal Reserve at its Dec. 15-16 meeting that called for GDP "to decline for 2009 as a whole and to rise at a pace slightly above the rate of potential growth in 2010." And the 2.3% trend growth that the budget office projects is well below the 2.5%-to-3% speed limit the Fed projected for the economy before the crisis.

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At 2.3% a year, growth in 2015 would be significantly below the 2.8% growth turned in by the economy in 2006 or the annual average of 3.1% from 2004 to 2006.

Are stocks cheap now?

If that projection turns out to be correct, it would be a huge negative for the stock market. Right now, investors and traders from Wall Street to Main Street, whether optimists or pessimists, are assuming an economic recovery that's much faster and much more robust than that.

To see why that's important, take a look at the current debate over whether stocks are cheap. The two sides debate how today's price-to-earnings ratio for the market compares with the long-term historical average and whether the normalized price-to-earnings ratio over the past 10 years shows stocks to be cheap or expensive.

Almost no one is considering the possibility raised by the Congressional Budget Office projections: that we could be looking at a long period where economic growth will be below both the long-term and the 10-year averages. A period of lower-than-average economic growth would lead to lower-than-average earnings growth. In that kind of environment, I'd expect-lower-than average price-to-earnings ratios, too. If that's what we're looking at, the market as a whole certainly isn't cheap yet.

Budget office may not be totally wrong

These are all just projections, of course. And you're entitled to take them with a grain of salt. The figures are all skewed by the peculiar way that the government counts its spending.

For example, the budget office projects the deficit will drop to $200 billion by 2019, but that assumes Congress won't keep or replace any of the Bush administration tax cuts due to expire in 2010 and that Congress will suddenly decide to let the full effects of the alternative minimum tax hit the middle class. Only a government accountant would be willing to assume that our politicians will act so clearly against their self-interest by casting votes that will send them into retirement.

But I can't dismiss the budget office projections out of hand. Conventional economic wisdom says the speed limit of an economy -- the maximum growth rate without inflation -- is a result of growth in the size of its labor force (the number of workers and the hours they work) and the growth in productivity of those workers. Before the current crisis, economists were worrying that an aging population in the United States -- and indeed around the world -- would reduce the speed limit.

The population in most of the developed world is growing very slowly to begin with. And those aging populations contain a smaller percentage of young workers and a higher percentage of retired or semiretired workers. (An additional 67-year-old who holds down a 20-hour-a-week job is certainly working, but that worker doesn't grow the economy as fast as an additional full-time worker would.)

Continued: The pattern of productivity growth

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