How to Profit From a Slowing U.S. Economy In the Second Half of 2010

[Editor's Note: This is the latest installment in Money Morning's ongoing Midyear Economic Forecast series, which has covered such topics as oil, gold, and the U.S. dollar.]

As much as the architects of the U.S. stimulus might otherwise wish, it's becoming increasingly apparent that the U.S. economy won't be hot-rodding its way into a higher gear in the year's second half.

At best, the U.S. economy will chug along in low gear - managing only minimal overall growth, while bouncing over economic speed bumps that exist in more than a few key sectors. At worst, the engine of economic recovery will sputter, or stall completely - leaving Americans stranded alongside the fiscal roadside, or to roll backward into a double-dip recession.

Most of the reasons underlying this assessment were clearly laid out in Money Morning's comprehensive Midyear Economic Forecast series article, "The U.S. Economy Is Headed for a Second-Half Slowdown." For our purposes, a brief summary of some of the recent statistical data will suffice, most notably:

  • Although growth in U.S. gross domestic product (GDP) for the second quarter is expected to come in at 3.8% - up from a sickly 2.7% annual rate in the first quarter - that's still well below the growth levels needed to sustain a healthy economy. It's also still sharply lower than the 5.6% growth achieved in the fourth quarter of 2009, when the recovery seemed to be on track.
  • Given population growth, economists say growth of 3% is needed just to break even, and 5% or more is a must if job creation is to expand - which isn't happening. Just 431,000 jobs were added in May, versus expectations of 513,000. Of that total, 411,000 were temporary - linked to U.S. Census hiring.
  • The U.S. Federal Reserve has revised its economic outlook downward, pledging on June 23 to hold interest rates at artificially low levels in a continuing attempt to prop up what it called a "faltering" recovery - one that might not return the U.S. to prosperity until well into 2012.
  • The Conference Board's Index of Leading Economic Indicators was flat in April and rose just 0.4% in May, both less than forecast and both signaling slower growth in the second half of 2010.
  • The level of consumer spending, which can account for as much as 70% of U.S GDP, was revised downward to just 3.0% in the first quarter, with even lower numbers expected when the second quarter reports come out. Retail sales fell sharply in May, ending a seven-month winning streak, and total spending plunged by 1.2%. The drop in spending was reflected in the level of orders for durable goods, which fell by 1.1% in May (though they actually rose by 0.9% when the transportation sector, which includes autos and commercial aircraft, was excluded).
  • Business activity showed little sign of taking the growth burden away from consumers, as the Philadelphia Federal Reserve Bank (Philly Fed) Index fell to 8.0 in June from 21.4 in May, a clear indicator that growth in the U.S. manufacturing sector is softening. On the plus side, businesses have the ability to spend if they want to, since Corporate America is currently sitting on its largest cash hoard in history.
  • Consumers are unlikely to start opening their wallets without a significant improvement in the employment situation - and there's been none. The number of new weekly jobless claims continues to average above 460,000 - and economists say it's hard to achieve any meaningful growth until the number of new weekly claims falls below 400,000, and stays there. Overall, the June unemployment rate was 9.5%. That was down from 9.7% in May, but the decrease didn't warm the hearts of economists who say the rate decreased only because so many discouraged workers quit looking for work.
  • That consumer concern was reflected in Tuesday's report of a huge drop in the Consumer Confidence Index - from 62.7 in May to just 52.9 in June. 
  • Despite 30-year mortgage rates that are below 5.0%, housing demand continues to fall. According to the Mortgage Bankers Association, mortgage applications fell 5.9% in the mid-June report, while refinancing activity declined by 7.3% and applications for new home loans fell 1.2%. Things are also likely to get worse, according to the National Association of Realtors (NAR), which predicts a steady increase in foreclosures through the remainder of the year, with more homeowners getting "under water" on their loans, delinquency rates (now at 14%) rising and sales rates continuing to decline.
  • Although U.S. protectionists view China's recent decision to let the yuan appreciate against the dollar as a major victory, the American economy is likely to see little benefit in the form of cheaper imports. That's because roughly 70% of the price Americans pay for imported products is due to the costs of shipping, advertising, sales expenses, rents and profit margins. Thus, even if wages rise in China and the yuan gets steadily stronger, the impact on prices here will be minimal.
  • The just-passed financial reform bill could turn into a major fly in the economic ointment. If critics are even partially correct, this well-intentioned - but hugely politicized - measure will almost certainly slow down job creation, keep credit tight, increase consumer costs, limit competition, substitute rules for  reason in the determination of "too big to fail" and, ultimately, add to the already massive federal debt load.

"Slowdown-Play" Stocks

So given all this "good news" heading into the second half of 2010 and beyond, what are investors supposed to do? How can you protect yourself - and even make more money - in a slowing economy?

There are actually three possible approaches, which you can use individually or in combination.

The first approach is to look beyond the overall economic situation, and focus instead on individual sectors and stocks that are either resistant to slowdowns or likely to grow in spite of (or because of) the deteriorating financial situation. Three stocks you might consider that fall into this category are:

  • Diageo plc (NYSE: DEO), recent price: $68.00: A classic "sin stock," Diageo will benefit from the reality that consumers tend to drink more when times are bad. And few companies are better-poised to capitalize on this reality than London-based Diageo, which distills, brews, bottles, packages, distributes and markets fine spirits, beer and wine. The company's brands include Smirnoff, Johnnie Walker, Captain Morgan rum, Bailey's Irish Cream, J&B scotch, Tanqueray gin, Crown Royal whisky, Guinness stout, Beaulieu Vineyard wines and countless others. The stock made a 52-week high of $71.99 in late April, sold off with the rest of the market in May, but bounced nicely off support at $60 and has been heading higher again. The company has solid earnings of $3.64 a share and pays a dividend of $1.77, good for a yield of 2.6%.
  • ArthroCare Corp. (Nasdaq: ARTC), recent price: $26.54: Just as people continue to drink in bad times, they also continue to get sick, and to treat their illnesses - a trend likely to ramp up under the new healthcare reform plan. ArthroCare develops, manufactures and markets medical devices used in the application of its patented, minimally invasive "Coblation" technology, which uses disposable surgical wands that employ radio waves to treat a variety of orthopedic conditions. The company experienced a sharp increase in revenue and first-quarter income from operations of $15.1 million, up from a loss of $3.9 million in the same quarter a year ago. The stock is also a favorite of the funds, with 77% of its outstanding shares held by institutions, including 3 million by Fidelity alone.
  • Yum! Brands Inc. (NYSE: YUM), recent price: $40.07: Even if the U.S. economy won't benefit that much from higher wages in China and a stronger yuan, U.S. companies that have hefty sales in China will - and Yum! is a leader in that category. With 37,000 restaurants in 110 countries - including KFC, Pizza Hut, Taco Bell, A&W, Long John Silver's and others - plus packaged-food items under the same brands, Yum! stores are a favorite of China's exploding middle class. The stock has a 52-week range of $32.49 to $44.00, earnings of $2.26 a share and pays a dividend of 84 cents.

Partnering Up

The second approach investors can take when economic growth is slow - especially when interest rates are also in the cellar - is to forget about capital gains and focus instead on income. That means concentrating on high-dividend stocks - or, for really big yields, so-called master limited partnerships (MLPs). Since dividend stocks have been frequent Money Morning topics (see the May 29 article, "How to Fuel Your Retirement with Dividend Cash"), I'll just mention a couple of MLP prospects here:

  • Linn Energy LLC (Nasdaq: LINE), recent price: $26.65: This Houston-based partnership develops gas-and-oil properties throughout the U.S. – but not offshore. At the start of the year, it had 1,712 billion cubic feet equivalent of oil and gas reserves, and operated 4,688 wells. With a market capitalization of $4.17 billion, Linn pays out $2.52 a year, equating to an 8.9% yield.
  • ONEOK Partners LP(NYSE: OKS), recent price: $68.75: This Tulsa-based partnership focuses primarily on the gathering, storing and transportation of natural gas, with a vast network of interstate pipelines, plus tank facilities and tanker trucks. Operations extend from Kentucky and Tennessee to Montana and from Wisconsin to Texas. With a market capitalization of $7.1 billion, the shares pay out $4.44 annually, for a yield of 6.46%.

The third - and most broadly defensive - approach is to purchase specialty exchange-traded funds (ETFs) that are designed to move in the opposite direction of a major market index. These so-called "inverse ETFs" use futures, options and other assets to create a passive portfolio that's expected to mirror the movements of leading indexes, but in the opposite direction. In other words, when the market falls, you profit.

The shares trade on stock exchanges, just like regular equities. Four of the leading inverse index ETFs are:

  • Short Dow30 ProShares (NYSEArca: DOG), recent price: 53.60 - Inversely tracks the Dow Jones Industrial Average.
  • Short S&P 500 ProShares (NYSEArca: SH), recent price: $54.53 - Inversely tracks the Standard & Poor's 500 Index.
  • Short QQQ ProShares (NYSEArca: PSQ), recent price: $44.65 - Inversely tracks the Nasdaq 100.
  • Short Russell2000 ProShares (NYSEArca: RWM), recent price: $42.84 - Inversely tracks the Russell 2000 Index.

Finally, if you don't want to shake up your entire portfolio or spend hard-to-come-by cash on purely defensive measures, the one thing you should definitely do to ride out the economic slowdown - assuming it will be accompanied by a flat or mildly bearish market - is write "covered call" options on your existing stock positions.

With market volatility as severe as it has been in recent months, option premiums are very high, meaning you can frequently bring in an extra $200, $300 or more by selling a relatively short-term (two or three months to expiration) out-of-the-money call against every 100 shares of a stock you own (at least those priced at $10 a share or more). This brings in added income and provides a couple of dollars of extra price protection should the stock pull back in the near term.

The worst that can happen is the market will rally before the calls expire and you will have to sell your shares - at a price higher than you could get for them today. Not a bad "defensive" outcome - especially since you get to keep the premium you receive either way.

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