The Most Dangerous Way to Invest Today

Another lesson that must be heeded is that "bottom up" research is a downright dangerous way to invest. To review, "bottom up" research looks at businesses first and de-emphasizes macroeconomic factors. If this market has taught us anything, however, it's that ignoring the economy can have dire consequences.

No Fa-Fa-Fa-Foolin'
Picking a stock without considering the economic environment is like picking out your clothes in the morning without considering the weather that day. Sure, that Def Leppard 1987 Hysteria Tour T-shirt may be comfortable and give you tons of street cred, but it's just not practical in a foot of snow.

All joking aside, no matter what sector you're looking at, there are macroeconomic factors that will make a big difference to your investing thesis -- durable-goods orders if you're looking at manufacturers, housing starts for homebuilders.

Right now, for example, companies dependent on consumer spending are facing some serious headwinds:

• The American labor force is weakening. 5.3 million Americans are claiming jobless benefits -- a record high. Unemployment sits at 8.1%. Add that figure to the 16% underemployment rate (part-time workers who want to work full time) and you have nearly one-fourth of the American workforce not contributing its full potential to the economy. These figures could get higher, since they haven't even taken into account the massive layoffs recently announced by United Technologies (NYSE: UTX), JPMorgan Chase (NYSE: JPM), and Texas Instruments (NYSE: TXN).

• Consumer credit is drying up. To compound the problem of unemployment, credit card companies like Discover Financial Services (NYSE: DFS) have become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. With prime credit card delinquencies up 23% in just the past three months, it's hard to blame them for these moves. But the combination of less available credit and less income from employment will inevitably lead to less spending.

• Baby boomers are being walloped by this economy. This economy couldn't have come at a worse time for the 78 million or so baby boomers approaching or already in retirement. According to Fidelity, at the end of 2007, its 401(k) participants ages 60 to 64 held a median 66% of their portfolios in equities. Given that the S&P 500 is down 48% since the end of 2007, it's reasonable to assume that the median boomer 401(k) lost about 30% to 35% of its value in just over 12 months. Besides the stock market losses, an estimated $6 trillion of wealth has been wiped out as a result of the real estate market crash of the past two years, leaving a good percentage of boomers underwater on their mortgages.

This new reality is significant on many levels, but the biggest consequence of a poorer boomer generation may be found in the retail sector. The boomer demographic accounts for about 40% of total consumer spending (about $3.8 trillion annually). Since consumer spending makes up 70% of our GDP, you can see how much a suddenly stingy boomer generation can hurt our economy.

If boomers cut just 10% of their $3.8 trillion in annual spending this year, it could set GDP back some 3%. Less boomer spending would hurt retailers across the board, but particularly those that sell highly discretionary, nonessential items, like Tiffany (NYSE: TIF) and Nordstrom (NYSE: JWN).

Where we're left
Despite these mounting economic woes, there are still stocks worth buying in this market. But the research process must begin with a macroeconomic analysis, followed by a thorough vetting of businesses.

Since we launched our Motley Fool Pro service in October, we've taken the plight of the U.S. consumer very seriously, focusing our research on companies that produce goods and services that people need, versus what they want. For example, we'd be much more inclined to research a stock like Johnson & Johnson versus a beaten-down retailer like Abercrombie & Fitch (NYSE: ANF). Consumers can do without $100 blue jeans, but they are much less likely to do without things like Band-Aids, Sudafed, and Tylenol.

Even though Abercrombie may look like a value at the moment from a bottom-up approach, it could be an even better value six months or a year from now. After all, even value is vulnerable without a catalyst to unlock it, and there appears to be no economic catalyst in sight for high-end consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for it to rebound.

At Pro, we're interested only in buying undervalued stocks with both strong fundamentals and positive economic support. Our top priority is accuracy, and we have a goal of generating positive returns with at least 75% of our investments. This means we must not only be selective with the investments we make, but also fully consider the economic environments in which they operate.

Copyright © 2008 Universal Press Syndicate.