“This is a mental recession,” not a real one, asserts former Texas Sen. Phil Gramm. The current advisor and co-chairman of Republican candidate John McCain’s presidential campaign went on to state: “We have sort of become a nation of whiners…complaining about a loss of competitiveness, America in decline.”

Not surprising, Gramm’s comments have already drawn a great deal of fire since they were issued Thursday. Even his boss felt it necessary to distance himself from them, retorting “America is in great difficulty, and we are experiencing enormous economic challenges, as well as others. Phil Gramm does not speak for me. I speak for me. So I strongly disagree.”

Certainly, it doesn’t take much more than a scan of today’s headlines to conclude the US economy has, at the very least, hit an extremely rough patch. This week, for example, speculation has grown that Freddie Mac and Fannie Mae—who are essentially the mortgage lenders of last resort—may need nothing less than a full-scale government bailout to stay afloat.

That’s only the latest body blow to the troubled financial services industry. Sector stocks have been in a virtual free fall this week, and investors are increasingly anticipating at least one more high-profile meltdown of a money center or regional bank in the coming months.

The troubled housing, which has been at the root of most banks’ woes, has shown some signs of stabilization in recent weeks. Pending home sales for May, however, came in far worse than anyone expected, falling 4.7 percent versus a 7.1 percent gain a month earlier and a consensus projection for a 2.8 percent drop. That suggests US homeowners are going to feel more pain, unless they happen to live in the handful of areas where prices continue to defy gravity.

Rising gasoline prices don’t mean a lot to the wealthiest Americans. But they are putting a major squeeze on the middle class. Coupled with rising electricity prices—which are being pushed higher by surging natural gas—that adds up to big-time pocketbook issues and a threat to consumer spending. It’s also increasingly a life-and-death challenge for sectors that use large amounts of vehicle fuels, particularly airlines and other transportation providers such as trucking.

And energy’s far from the only major commodity that’s putting upward pressure on costs. This year’s off-the-chart demand growth in Asia for everything from agricultural products to base metals such as copper may be moderating somewhat. But as Yiannis Mostrous and I have pointed out in our advisory Vital Resource Investor, supply challenges are increasingly picking up the slack, particularly growing electricity shortages in major producing nations such as Brazil, Chile and South Africa.

Surging commodity prices to date haven’t had much impact consumer prices, mainly because companies in most industries have been unable to pass them through. The recent surge in prices for steel and aluminum, however, indicate the pressure is rising on earnings in many industries.

The result is basically the US economy is between a rock and hard place on commodities. If these higher costs are passed on to consumers, the result will be more pressure on spending and on the industries that depend on it, such as retail. And if the higher costs aren’t passed through, the result will be compressed corporate earnings and, therefore, curtailed plans for growth and probably layoffs in the most-affected sectors.

Even commodity producers themselves could prove vulnerable. The selloff in many resource stocks of the past couple weeks, for example, was largely the result of an expectation that the economy simply wouldn’t be able to absorb the higher prices and that demand and prices would tumble as a result.

On the other hand, before we completely dismiss Mr. Gramm’s views, it’s worth pointing out there are some dissenting numbers. For one thing, unemployment has yet to rise to recession-like levels. The official unemployment rate has risen in recent months to 5.5 percent. That number, however, is based on survey data that are frequently revised.

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Meanwhile, initial unemployment insurance claims—the hardest number for gauging employment because it represents actual checks issued—unexpectedly dropped sharply this week to 346,000. That was down from a more recession-like 404,000 the prior week and well off consensus projections for claims of 395,000.

Of course, employment is a lagging indicator of economic health, and these numbers could well worsen again going forward. Moreover, real wage growth was basically stagnant for the entire recent economic expansion, so even a continued drop in claims in coming weeks won’t erase cost pressures on consumers.

The numbers, however, are a pretty good sign that not every sector of the US economy is faltering. And that’s a critical distinction for investors in this increasingly turbulent market environment.

There are basically three challenges confronting US companies today and their stocks, bonds and other listed securities. First, there’s slower growth itself and the potential impact on sales. Second, there’s the tight credit market conditions, which, combined with stock market weakness, is forcing companies to rely on their own resources rather than issuing new capital. Finally, there’s the surge in commodity prices and the potential pressure on operating costs.

In a bear market, almost anything can get hit on a given day. The difference is companies able to deal with these challenges effectively will recover quickly. In fact, over time, they may even gain ground during these hard times, as investors try to orient their portfolios to safe havens.

This has been the secret for utility stocks this year. At the outset of the bear market, many questioned the sector’s ability to withstand weakness in the economy, citing the meltdown of 2001-02.

As I’ve pointed in this service, as well as Utility Forecaster, however, the utility industry today is a far different animal now than it was earlier this decade. Then, we were looking at a highly leveraged sector burdened by severe overcapacity and extreme regulatory risk. Since then, companies have systematically slashed debt and operating risk, while repairing relations with regulators.

As a result, the industry is the healthiest financially it’s been in decades. There are challenges ahead, notably a projected $1.5 trillion-plus in capital spending and rising fuel costs. But at this juncture, we’re still seeing rising credit ratings, dividend increases and even insider buying. Throw in the fact that this is a regulated, essential service industry and that’s pretty firm footing for the current environment.

In fact, there’s literally no other sector with these advantages, which explains why investors are still viewing utilities as havens. And there are companies in other sectors whose earnings continue to hold up. As long as that’s the case, their ultimate recovery will be assured, even if things continue to roll over.

Since this bear market began in mid-2007, my view has been that numbers are the key. My approach has been to focus closely on companies’ earnings numbers when they’re announced and to watch for clues as to future numbers in between the reports.

As long as companies show strength—i.e., they’re standing up to the challenges facing the US economy—I’ve stuck with them. When they’ve appeared to show weakness, I’ve recommended selling and moving into something else.

As I wrote last week, this isn’t a foolproof strategy for completely avoiding bear-market losses. The only way to really do that, unfortunately, is to be 100 percent cash, and even then, you’d better have a grip on who’s writing the interest checks.

As the market action of the past few weeks has proved, even the strongest companies can take hits on the days when fearful investors seem to abandon the market entirely. But focusing on the numbers does ensure against the biggest danger of bear markets: wholesale blowups such as those that hit the utility sector in 2001-02 and are smashing up financial sector stocks now.

Even board members can be taken by surprise by events at their companies, so we can’t expect to anticipate every trouble spot. Using earnings numbers—and, more important, the numbers behind them—as our guide also means we’re going to be selling a floundering company after damage has been done—and possibly a great deal of damage.

We will, however, largely avoid the complete wipeouts that are so damaging to portfolios in bad markets. Equally important, we’ll avoid getting badly whipsawed out of good positions because of unsubstantiated rumor and innuendo. That will keep us in the game with the companies that have a genuine chance of recovery.

Here’s a brief roundup of various income investing sectors now, the potential risks and rewards and where they’re likely to head in coming months. For more on Canadian trusts, be sure to sign up for the complimentary weekly Maple Leaf Memo. Note I also publish a paid advisory called Canadian Edge covering the entire trust universe and a growing array of high-yielding, high-potential corporations.

Utilities—Even utilities face challenges here in mid-2008. Vectren Corp (NYSE: VVC), for example, issued a rare earnings warning this week, reducing its expected company guidance on lower projected profit at its unregulated energy operations. The majority of companies, however, should report very strong profits for the second quarter on solid regulated utility results and higher power prices in many markets. Even Vectren is holding its guidance for utility operations, which are the bulk of its earnings, and its dividend is in no way threatened by the revised guidance.

Interesting, there were no dividend cuts in the power sector over the past 12 months, while more than 90 percent of companies raised dividends. We want to watch regulatory cases in some states, notably New Mexico and New York. But the prognosis generally looks good for now, even for utilities that are passing through hefty fuel costs.

Super Oils—This group could be on the verge of a production windfall if the US government winds up reducing restrictions on offshore drilling and in other areas now off limits for environmental reasons. In the meantime, earnings are going to be strong again in the second quarter, largely on higher energy prices, as Chevron’s (NYSE: CVX) preannouncement this week indicates, and their huge cash hoards provide a margin of safety not shared by other energy companies. The best plays in the group are those with the potential to increase production even without relaxed US restrictions, especially Chevron and ConocoPhillips (NYSE: COP).

Canadian Energy Trusts—This group is easily the cheapest subsector in energy. One reason is that realized prices have so far lagged the upward moves in oil and natural gas. That’s changing rapidly, however, as lower-priced hedges come off and higher-priced contracts for future sales are inked.

The second quarter should be very explosive, particularly for natural gas-weighted trusts. But the best bets are still the biggest companies built for sustainability, such as Enerplus Resources (NYSE: ERF). Note that trusts’ distributions were well covered, selling oil at less than $80 per barrel and gas at less than $8 per million British thermal units in the first quarter. Prices will have to fall at lot further than that—and stay there—to have a negative impact on trusts’ dividends.

Canadian Business Trusts and REITs—This group sold off this week in tandem with Canadian energy trusts, despite the fact that energy prices have little or nothing to do with their earnings. The numbers are key here, and the second quarter will be critical.

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But trusts such as Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) are already pricing in a big drop in earnings, despite accelerating growth in the first quarter. That sets a very low bar for the stock when the new numbers come out, and that’s always good for future share price.

Bond Funds—My view on these has always been to focus on stability, rather than reaching for yield. Bigger yields always mean more risk and, therefore, less protection from rocky markets. I continue to favor low-duration (exposure to interest rates), low-expense, open-end funds, such as those offered by the Vanguard group.

It’s OK to invest in top-performing closed-end funds, but watch those premiums. They have a tendency to become discounts in a hurry when the market mood changes, and that can turn a profit into a big loss even if the fund manager does his or her job and maintains portfolio stability.

Individual Bonds and Preferred Stocks—My favorites here are definitely utility preferreds. Again, my general rule with buying any individual preferred stock or bond is to only choose from companies whose common stocks I’d want to own.

Yes, bond and preferred stock dividends are safer than common dividends. In fact, companies have to be up to date on their interest and dividends before they can pay a dime on the common stock. But that distinction won’t keep a troubled company’s bonds or preferred stocks from plunging to a deep discount or worse under the wrong circumstances.

Utility preferreds and bonds are backed by essential service companies whose stocks are considered recession resistant. The individual bonds and preferreds aren’t AAA-rated, but they’re not AAA-priced either; and in all but the worst-case scenario for the economy, they’re almost as safe.

US REITs and Financials—History shows it’s always best to have at least some exposure to every income-producing sector in your portfolio, no matter how bad things get. In REITs, the apartment sector still offers value and in fact is one of those rare areas where things are still steady as the number of renters grows. The group also never reached the heights other REITs did during the boom time.

I also like Canadian REITs, as that country’s property market remains far healthier than the US and the REITs there pay several percentage points higher in yield as well.

As for financials, Berkshire Hathaway (NYSE: BRK/B) is a good choice if you’re basically fearful of the entire industry, as I am. I think there will be a time when we’ll want to wade back into the likes of Regions Financial (NYSE: RF), Citigroup (NYSE: C) and other “can’t let them fail” names, and it may be soon. But I’m not ready yet.

Limited Partnerships (LP)—There are undeniably still some dogs in this group. That’s the case any time there’s a massive wave of new issues (as was the case last year), followed by severe stress tests. And there are some LPs that have succumbed to the perils of over-leverage, as falling unit prices have made it impossible to issue equity cost-effectively.

On the other hand, there are a number of LPs that appear to be getting whipped on Wall Street for no real fundamental reason. My favorite group here is energy infrastructure, which I’ve covered for many years in Utility Forecaster. These LPs make their money from fees for use of expanding asset bases. Cash flow grows every time a new asset is added, such as a pipeline, gathering or processing facility.

And important, there’s little or no speculative building going on. Every project is virtually 100 percent contracted out before the first shovelful of earth is tossed.

Some investors are worried about the use of revolving credit debt and the ability of LPs to permanently finance it. That’s not a concern, however, if you own the likes of Enterprise Products Partners (NYSE: EPD), which incidentally has been one of the most heavily purchased companies by insiders in recent weeks.

Foreign Currencies and Gold—The rapid decline of the US dollar in recent years has set off an issuing frenzy of ways to bet on further drops in the greenback. I’ve always thought it wise to have some of your money in other currencies but only when it’s backed by a real asset. Preferably, that’s a dividend-paying stock of a great company, which will give you growth.

For example, the strength of the Canadian dollar is just another benefit to owning trusts. I also like some of the European utilities, such as Enel (OTC: ESOCF). And of course, owning some gold will go a long way toward hedging your portfolio against any decline in the US dollar, as well as higher inflation. Note vital resource stocks such as Freeport-McMoRan Copper & Gold (NYSE: FCX) also pay a modest yield.

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