Despite the fact that the stock market is flirting with all time highs, there is ample evidence that the economy is relatively weak. Let us look at the signs and then I will discuss how investors should prepare their portfolios.
The first and most obvious sign is the fact that first-quarter GDP came in negative — specifically at -1 percent. This figure was weaker than the anticipated 0.5 percent decline. Many economists will argue that the economy was so weak in the first-quarter because of extraordinary weather conditions. But while this may account for some of the weakness, it cannot account for all of it.
The second is that inflation is on the rise. While the stock market has been relatively flat, we have seen strength in several commodity markets, particularly in the energy markets and in agricultural commodities. This means that the prices of things that people buy everyday are rising, or if they aren’t, then the companies that provide them are seeing their profit margins decline, and this leaves them with less capital to invest in their businesses. So not only will inflation hurt consumption, but it will hurt investment as well and this portends badly for the economy.
The third is that we saw that consumer spending declined 0.1 percent in April. In my mind, this was a major blow because it happened in April, which is when the economy was supposed to have turned around along with the weather. But in the same report, March data was revised upwards so that consumer spending actually rose by 1 percent. So if rising consumer spending is coinciding with a contracting GDP, what happens when consumer spending declines, as we saw in April? This suggests to me that optimistic views regarding second-quarter GDP will be largely offbase.
Finally, the Federal Reserve is tapering its quantitative easing program. In short, this means that the money that was being pumped into the economy in order to prop up the bond markets and to encourage banks to lend is entering the system at a slower rate. It is no wonder that the stock market’s ascent began to decelerate towards the beginning of the year as stocks have risen and fallen with Federal Reserve policy — tapering and ceasing of quantitative easing programs over the past few years have coincided with weaker GDP figures and a declining stock market.
These four points all suggest that there is a heightened risk of a recession. They also suggest that with some exceptions now is an excellent time to sell stocks. But which stocks are worth holding on to, and which stocks should you sell?
Let’s look at the latter question first. Investors should sell shares in companies that are economically sensitive. For instance, shares of industrial companies and consumer product companies that sell discretionary products should be sold, or at the very least you need to put them on a tight leash (i.e. you need to use stop orders.) Shares of companies that aren’t generating a lot of free cash-flow should also be sold. For instance, I don’t think now is a good time to be taking positions in Internet stocks such as Twitter (NYSE:TWTR) and Amazon (NASDAQ:AMZN). While they are growing their revenues substantially they have no profits. This makes them vulnerable to the downside if investor sentiment turns sour or if their growth begins to decelerate.
On the other hand, there are companies worth taking stakes in. For instance, my second point suggesting economic weakness was rising inflation and rising commodity prices in particular. There are many companies that benefit from rising commodity prices that are generating a lot of free cash-flow such as fertilizer producer CF Industries (NYSE:CF) and oil giant Exxon Mobil (NYSE:XOM). These companies trade with price to earnings multiples below that of the S&P 500, and they service recession resistant industries — namely, agriculture and energy.
Investors should also consider taking stakes in other recession resistant companies. Wal-Mart (NYSE:WMT) is a good example, and its share price has been weak due to a couple of quarterly profit declines that provide investors with an opportunity. Other discount retailers such as Dollar Tree (NASDAQ:DLTR) cater to consumers looking for bargains. Dollar Tree has the potential to gain business in a recession, and it recently reported an increase in quarterly sales and profits.
Finally investors should consider taking positions in gold and in cash. These assets clearly are not in favor right now, but they are good places to be when the stock market declines.
Disclosure: Ben Kramer-Miller is long CF Industries and Exxon Mobil. He owns gold coins.