Judging by the market’s performance this week, investors seem to be adjusting to the fact that we’re probably facing a fairly prolonged recession. The US economy contracted at a 0.3 percent annualized rate in the third quarter as personal consumption nosedived at the fastest rate in 28 years, falling 3.1 percent. But despite what most would take as bad news, the major indexes actually gained more than 2 percent yesterday.

Those gains, coupled with the huge run-up on Tuesday in anticipate of the Federal Open Market Committee’s (FOMC) half-point rate cut, fueled a huge rally with double digit gains for the week on all three indexes. The Dow Jones Industrial Average tacked on 11.3 percent for the week; the Nasdaq Composite climbed 10.9 percent; and the S&P 500 gained 10.5 percent.

The plunge in personal consumption is hardly surprising. Rosy headlines cheering the fact that both personal income and disposable personal income rose 0.2 percent in September are extremely misleading because, although they did increase modestly in the month, real per capita disposable income took its sharpest decline since 1949 in the third quarter, falling 9.6 percent.

 
One reason behind the sharp decline is the distorting effect of the stimulus checks the majority of Americans received in the second quarter, but there’s an even more straightforward reason as well. Real wage growth is sluggish at best, with weekly median wages rising only about 8 percent between 1980 and 2007, hardly keeping pace with inflation.

And although Americans are profligate spenders, as few know the true meaning of saving, that’s a big part of the reason that credit exploded. It’s simply very difficult to make ends meet in a country where wage growth isn’t keeping up with the cost of living.

 
In a country where about two-thirds of our GDP is tied to consumer spending, pinching the consumer is no way to keep the economy rolling. We spend disposable income on the niceties of life. And with consumer confidence plunging to 38 in October from 59.8 in September, consumers will probably be paying off debt or holding on to their cash for the time being.

The other problem that will continue to impede our economic recovery is the fact that housing prices remain well about the historical norm. True, not everyone will be able to afford to own their own home, but with housing prices still generally too high, a large swath of homebuyers--if they have any common sense--are still priced out of the market. It wouldn’t be surprising to see at least a further 15 to 20 percent decline in home prices.

And that makes this month’s new home sales data a bit of a red herring. Headlines were splashing Monday that new home sales rose 2.7 percent in September, a point which no one argues. But if you dig deeper into the data, a fairly clear picture emerges to explain why we saw the surge. The largest increases in sales came from homes priced below $300,000, with new home sales surging 22.7 percent in the West. The increase in sales was largely a function of homebuilders out West slashing prices and offering unheard of incentives to offload inventory.

Again, that’s a good thing on the surface. Nationwide, the supply of new homes fell from 11.1 months in August to 10.9 months in September, but that’s just new homes. Overall inventories nationwide are remaining relatively static, with sales barely keeping pace with foreclosures. And another large batch of adjustable-rate mortgages--which we covered early on in the housing bubble--will be resetting next year, peaking around mid-2011, meaning supply problems are probably here to stay for at least another two to three years.

Election Results, Recession Fears and What Investors Should Do Next

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So although the steps that have been taken to unfreeze the credit markets and prop up the financial system have been critical, we still must take steps to keep people in their homes. The Federal Deposit Insurance Corporation (FDIC) and the Treasury Dept are currently working on a plan to provide guarantees on as many as 3 million at-risk mortgages, with individual lenders taking steps to keep troubled borrowers in their homes.

That would benefit all parties involved, though there are questions as to how effective the government program may be, given that there are legal issues that would have to be overcome, given the massive securitization of mortgages. At least there’s some movement on the issue. Propping up homeowners isn’t the last step in setting the path to recovery, but it’s certainly a critical one.

Overall, I wouldn’t be making any poorly thought-out bets on the American consumer. We’re facing a long, tough recovery process, which won’t be fixed by the upcoming election. But regardless of who the victor ultimately is, hopefully the pull of a second term will compel him to make the tough calls needed to right the ship.

Unemployment claims held steady last week, with initial claims unchanged at 479,000 after the previous week’s number was revised upward. Continuing claims declined slightly, falling to 3.715 million from 3.727 million. I expect a slight uptick in initial claims in coming weeks, as many large financials and automakers have announced that they’re planning additional layoffs over the next month. The current unemployment rate stands at about 6.1 percent.

Durable goods orders in September rose slightly, up 0.8 percent, with August orders revised down to a 5.5 percent decline, the largest drop in almost two years. The increase was largely on the strength of civil aircraft orders, which jumped 29.7 percent. Overall durable goods orders declined 1.1 percent with transportation-related items excluded.

Mortgage applications bounced off their eight-year low last week, rising 16.8 percent, as loan costs decreased slightly. The Mortgage Bankers Association reported that its purchase application index rose 8.5 percent, with applications to refinance jumping 28.5 percent.

The average interest rate for a 30-year fixed rate mortgage declined 0.02 percent to 6.26 percent, 15-year fixed-rate mortgages fell from 6.05 percent to 6.01 percent, and one-year adjustable rate mortgages (ARM) declined to 6.9 percent from 6.97 percent.

In this week’s issue of The Energy Letter, Elliott Gue looks at some interesting conservative plays in the energy sector. With many producers and pipelines beaten down by falling energy prices, there’s no shortage of opportunity.

For the past few weeks, I’ve been looking for signs of a broader market low and the potential for energy stocks to see a sharp rally into yearend.

In the Oct. 10, 2008, issue of The Energy Letter, Buy Energy Stocks During Downturn, I highlighted several indicators I’ve been watching carefully for signs that a low is in place. I believe we’re now seeing those signs, and I’ve been recommending that subscribers get more aggressive and play the coming dramatic yearend run-up in the group.

But just because I see the potential for a relief rally through yearend doesn’t mean that investors should simply focus on growth-oriented energy investments. The fact is that the recent market carnage hasn’t spared many sectors or stocks; even more defensive yield-oriented plays have been hit by the selling.

In fact, some of the best opportunities of all in the energy sector right now are in groups traditionally seen as defensive and, in many cases, downright boring. Investors have a rare opportunity to buy defensive stocks with conservative management teams to grow their dividends and lock in yields around 10 percent. Opportunities like this are hard to come by. Now is the time to take advantage of other investors’ panic and irrationality and lock in some sky-high yields.

Those willing to take on a bit more risk can earn even higher income than that. Some of my favorite aggressive income plays are yielding closer to 15 percent at the current time.

Inside my TES coverage universe, I see three yield-oriented plays right now worth considering: Master Limited Partnership (MLPs), corporate bonds issued by energy-related firms and covered-writes (covered calls). Let’s examine each of these yield-oriented plays in turn; subscribers to TES can expect a detailed look at each in an upcoming issue.

Master Limited Partnerships (MLP)

For those unfamiliar with MLPs, these stocks aren’t corporations but partnerships that trade on the major exchanges just like any other stock. You can purchase MLPs through your broker and will pay normal commissions just as if you were buying IBM or GE.

However, there are some key differences between MLPs and corporations. Chief among those are that MLPs pay no corporate-level taxation. Instead, these companies pass through the majority of their income to unitholders--MLP parlance for shareholders--as regular quarterly distributions.

These distributions aren't taxed as dividends but are extremely tax-advantaged. In most cases, MLP holders won’t have to pay tax on 70 to 90 percent of the distributions received until they sell their units. This allows significant tax deferral advantages.

Most US-traded MLPs focus on the energy business. The vast majority are involved in midstream operations. This generally means owning energy infrastructure assets such as pipelines, oil and gas storage facilities and natural gas processing plants. Some MLPs have branched out into other energy-related businesses, such as owning tankers, leasing capacity on production platforms and even actually producing oil and natural gas.

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The common thread linking most of these infrastructure businesses is that they’re extraordinarily steady and cash generative. For example, companies that own pipelines aren’t paid based on the value of oil or gas traveling through their pipes; instead, pipeline operators receive a fee linked to the volume of gas transported. In many cases, fees are partly or fully guaranteed under long-term contracts. In other words, once a pipeline is built, the owner can expect to receive regular, reliable cash fees with limited need for ongoing maintenance spending.

Because partnerships pay no corporate level tax, most of that cash finds its way into unitholders’ pockets. The average partnership in the industry benchmark Alerian MLP Index pays a yield of more than 9 percent; some pay yields of 15 percent or more. Even better, MLPs have a long history of increasing their distributions over time. In short, MLPs offer high, growing income.

I cover this group in TES; in addition, I am a co-editor of The Partnership, a newsletter solely dedicated to MLPs. Long-time readers will remember that I highlighted this group in TEL in the May 2, 2008, issue, New MLP Buying Opportunity.

Since that issue, the benchmark index for this group, the Alerian MLP Index, is trading lower but has handily outperformed both the S&P 500 and the S&P 500 Energy Index. While a negative performance is never a positive, in a market as messy and volatile as we’ve experienced this year, outperforming the broader indexes is a meaningful feat.

For the complete article, go to http://www.kciinvesting.com/articles/9627/1/Three-Ways-to-Reach-for-Yields/Page1.html.

Speaking Engagements

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.
 
Join Neil George, Roger Conrad and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.
 
Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011364 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.

Join Our Webinar

The Rebound: Investors are now desperately scouring the headlines and the Internet daily for any sign of a bounce. We can save you the trouble. My fellow KCI Communications editors and I will present a breaking news conference Nov. 6, 2008 at 1 pm ET. Join us for “Election Results, Recession Fears and What Investors Should Do Next” by registering here or calling 800-832-2330.

In the meantime, please check out our latest insights into the markets on our blog, At These Levels.