I’ve been reading Michael’s articles for about 3 years and it is good to see him finally getting some more publicity as a result of publishing his new book The Death of Capital.

Other Comments from the December market letter include:

1. Bad policy in the US will ensure the that boom and bust cycle will continue
2. The US economy showing signs of improvement but not as much as might be expected following a recession. The data is also not as positive as it is being seen by the markets
3. Europe (and the Euro) is in trouble with Spain Portugal, Greece, Ireland Belgium and Italy the most vulnerable
4. China boom to end at some point unless “they are unlike every other growing economy in the history of the world” –  People trusting numbers coming out from China are not wise.
5. He also gives a range of investment recommendations at the end of the article that are worth reading.

Thanks have to go to Wallstats.com and blog.mint.com for creating this amazing diagram.

I recently read an interesting article about the potential upsides that accompany a recession. With much talk of a recession in the coming months in Australia and one already on the cards in the USA, I thought it may be worthwhile to outline some of the positives that accompany the fear associated with a recession.

Ultimately, a recession will bring a slowdown in spending, a tightening in the job market and an increase in corporate restructuring and lay-offs. This, most people are aware of.

However, for those willing to use sound financial and business analysis, a recession can bring a wealth of opportunities and provide the necessary timing to enter a number of markets.

I like to think of a recession as a time where almost everything goes on sale because this outlines the number of opportunities that are available to the everyday person or investor.

I have outlined 2 main investment related benefits of a recession below and then summarised a few common benefits after that:

Reduced housing prices

Many of those who have bought investment properties looking to sell a short time later with hopes of high short term capital gains will not be impressed by the lower house sales prices that accompany a recession.

However, for those who have been considering purchasing a house or investment property (medium to long term) and have potentially already got a deposit ready, a recession may become quite advantageous.

Recessions are typically short lived and the lower housing prices will enable many of the people described above to actually enter the housing market cheaply with the likelihood of relatively short term capital gains when the downturn clears.

In this sense, recessions are also a great time to look for investment properties.

Inexpensive stocks

If you are the type of investor that is after long term capital gains, recessions are similarly a great time to buy company stocks as they are often undervalued.

This is because most people are taking their money out of the stock market in times of recessions and hence the prices of company stocks are driven down for reasons not always logically linked to the earnings of the company.

Understanding where the value is to be found involves understanding how to appropriately value a stock. An introduction to some factors affecting company valuation can be found in my blog on 9 key concepts to understand the valuation and earnings of companies.

To see a further discussion on the effect of the earnings of a company on stock prices, see my blog on what moves the stock market.

Low Mortgage Rates

During the time leading up to a recession, in many cases the Reserve Bank or the Federal Reserve will reduce interest rates resulting in cheaper debt to companies and lower mortgage rates to families and individuals.

This is done in an attempt to stop the country from falling into a recession. This fact, combined with cheaper housing prices, can provide an excellent time to invest in property.

Great Consumer and travel deals

As the recession worsens and people begin to purchase less and less, stores need to provide better deals and discounts to attract consumers and entice purchasing. This typically leads to discounts and low interest finance deals that can be particularly beneficial to the savvy buyer.

In addition to this, second hand bargains are even easier to find because there are less people looking to buy and more people looking to sell.

Most people do not think of travelling during a recession and hence it is a good time to consider doing so because the prices are typically lower. This benefit is added to by the better deals you are likely to receive while travelling.

Recessions are a great time to have a good think about your finances, cut your unnecessary spending in certain areas and think about investment in a number of underpriced goods as outlined above.

To read about the current economic recession, have a look a this visual guide to the financial crisis or read Tom Spencer’s blog on measuring the strength’s of the economy. Click here for the cheapest way to withdraw cash overseas if you are an Australian.

What factors move the stock market? What about individual stocks? How do interest rates affect the stock market and what does this have to do with the Consumer price index and inflation?

Many people know that economic factors such as corporate profits and interest rates tend to influence the movement of the broader stock market. However, I found it particularly interesting to actually analyse how these factors move the market and whether one should follow such trends when purchasing individual stocks.

Corporate profits and GDP

A drop in the Gross domestic product (GDP), the market begins to fear a recession and a subsequent drop in corporate profits. With worsening economic conditions, the market may enter a recession resulting in reduced demand for many company’s products.

Following on from this, many company’s earnings will be affected and the corresponding company stock price will fall (rationale outlined below). Thus, when the GDP and corporate profits fall, the market will suffer.

Interest rates, the CPI and inflation

There are two ways that interest rates can affect the movement of the stock market and it is important to understand the relationship between the consumer price index (CPI), inflation and interest rates to understand this.

Typically, when the CPI increases, the market fears inflation and this triggers interest rates to rise. Companies with debt will be forced to pay higher interest rates on existing debt, thereby reducing earnings (and earnings per share). This is the first reason that a rising CPI and interest rates will cause the market to fall.

Secondly, since inflation fears cause interest rates to rise, higher rates will make non stock market investments more appealing for the average investor. Why would an investor purchase a stock that may only earn 8 percent (and carries greater risk), when lower risk government bonds offer similar yields with less risk?

These inflation fears are known as capital allocations in the market (whether investors are putting money into stocks vs. bonds), and can substantially influence stock and bond prices. The market will usually redistribute investments from stocks to low-risk bonds when the economy experiences a slowdown and vice versa when the opposite occurs.

Should I follow the market?

An understanding of these factors is important but ultimately following this trend may not always be the ideal approach for the savvy investor. There are a multitude of opportunities to purchase undervalued companies during a slowdown in the market and as long as good company valuation analysis is completed, these times will provide some of the most profitable opportunities to purchase stock.

What moves individual stocks?

The only predominant factors that influence individual stock prices are earnings per share (EPS) and all things relating to rumours or speculation that may predict earnings per share. No other measure even compares to earnings per share (EPS) when it comes to an individual stock’s price.

Each quarter, public companies must report their EPS figures, and stockholders await the information in order to compare the actual EPS figure with the EPS estimates set by market research analysts. As an example, if a company reports $1.00 EPS for a quarter, but the market had anticipated EPS of $1.20, then the stock price will dramatically fall in the market the next trading day. On the flip side, if a company beats its estimates, its stock price will typically rally in the markets the next trading day.

There have been deviations from the principle of EPS being the central focus of stock price variation in markets over time. An example of this is where during the internet stock frenzy in the late 90′s and early 2000′s, investors believed that companies could operate at a loss for a year or two (low to nonexistent EPS) in the hopes of achieving substantial long term earnings as a result.

This is obviously an appropriate approach if you happen to have found the next Google or if you are committed to the company for the long term. However, if you are interested in short term profits or capital gains, the market is likely to move against you if you use anything other than the short term expected EPS of a company. This was evidenced by the market correction in 2001 where technology stocks drastically fell as a result of low to nonexistent earnings.

For a look into the benefits of an economic recession, click here.