The economy is improving, but plenty of hurdles remain. It's a confusing time for stock market investors.
There's no doubt that there are green shoots in the economy. The housing market, ultimately at the crux of the whole recession, may finally be starting to stabilise. Consumer confidence has risen. And company earnings weren't aren't as big a disaster as everyone thought they'd be.
But now is not the time to be complacent.
Delusions of Grandeur
Unfortunately, there's been very little evidence of a solid recovery. Sure, the financial crisis seems to be past, and the economy didn't collapse completely. After the turmoil that followed Lehman's failure in the US and the effective failure of Royal Bank Of Scotland (LSE: RBS) and HBOS here in the UK, the government's quick actions to shore up the financial sector have convinced people that the government won't let a big bank fail. Consequently, the sheer terror we experienced last fall has faded to mere paranoia.
But beyond that, it's unclear when the real economy will recover. Moody's, for example, recently cast a dampener on the UK banking sector, forecasting further losses of £130bn for the industry in the next few years as bad debts rise and pressure builds on profitability.
And as we found out, to our great cost, the health of the overall economy is intrinsically tied to the health of the banks. Moody's also noted UK consumers had a high level of debt and unemployment was rising. These factors were expected to feed into higher losses on secured and unsecured lending at the banks.
Sobering
It's all quite sobering, and somewhat easy to forget in light of the huge stock market rally over the past six months. If you've managed to hang onto your job through this recession, and therefore hang onto your house, you're probably relatively flush right now.
But don't forget the global economy has been propped up by government spending. Big Brother has been throwing money at the economy to try to reverse the vicious cycle of redundancies resulting in lower company sales, which in turn leads to more redundancies, which in turn results in even lower sales, which in turn… (you get the picture).
The Key To Recovery
But funding a recovery with huge government spending and massive debt is like using a defibrillator to treat a heart attack. It can work well in short doses, but it's completely unsustainable over the long term. Maybe the big car makers and dealers like Lookers (LSE: LOOK) and Pendragon (LSE: PDG) aren't complaining about the government scrappage scheme, but does anyone really believe that demand will be sustained once the scheme ends, probably in the not too distant future?
The government isn't the key to recovery. Neither are corporations. Consumer spending is what really matters, accounting for about two-thirds of the UK economy. But right now, consumers are acting as cheap as a politician who has to spend his own money.
It seems we have finally realised that re-mortgaging the house for a third time to fund another 40-inch TV for the new conservatory is not a sensible decision. And consumer confidence, while improving, only looks good when you compare it to the all-time lows it hit in January. In its latest consumer confidence survey, Nationwide said expectations had stabilised even if the consumer confidence index is still somewhere below "gloomy" on the lending group's scale.
But why should consumers be confident anyway? The unemployment rate is close to 8%, its highest level since 1995, and it's still rising. And you expect consumers to help the economy rebound? Good luck with that.
Mixed Messages
Despite all these problems, it's still hard to form a firm conclusion. Employment is a lagging indicator -- companies hire when they need workers, not because they think that there's a chance they'll need workers next year. Maybe we just need to wait, and those green shoots will blossom. If everything looked bright and cheery, it would hardly be the Great Recession now, would it?
All in all, it's a very confusing environment in which to be an investor. If this is the start of an economic recovery, the stock market could still run another 25% higher from here. So scaling back your portfolio might not make sense. But if this is just an economic head fake, do you really want to relive the last few months of 2008?
The solution is to focus on value stocks. Value investing really shines right now because it provides the best of both worlds. If you can buy a company for 50% of its fair value, you make a 100% return if the shares returns to more rational pricing. But, since shares tend to gravitate toward a fair price, value stocks can also cushion your portfolio during a bear market. You can get the upside, with less downside risk.
The Foolish Bottom Line
Our Champion Shares newsletter has illustrated these benefits nicely. Chief Analyst Maynard Paton's average pick tipped during the 12 months to 8 September 2009, a period encompassing the massive plunge, is up 41%, whilst the comparison FTSE All-Share is 'only' up 22%. It's that combination of excellent upside potential with a reduced downside that makes value stocks so compelling right now. If you'd like to read about our top picks right now, we're offering a free trial to Champion Shares.
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who doesn't have an interest in any of the companies mentioned in this article.
