"The more I find out, the less I know."

Friday - February 22, 2008 at 11:07 AM in

Economic outlook


The majority of pundits lately have been thinking deeply about the economy, at least when they're not obsessed with the scandal du jour in the presidential contest.
I'm not a pundit, but I occasionally pretend to be one on the Internet, and I've been thinking about the economy lately. Here's my conclusions:

First, we are probably in a recession. When the dust settles, we'll probably decide that the recession began sometime between November and January.

Second, I think we're probably close to the bottom right now (but we won't know that for a good six months or more). I base this on these observations:

1) The stock market has been basically flat for a month now, neither moving significantly up or down. We may have actually set the bottom in January, though we haven't moved enough up to be sure that there won't be another bottom in the near future.

2) The Fed is pumping huge amounts of liquidity into the economy, and that money is going to have to go somewhere. Near-term it seems to be going into super-safe investments like government bonds (and especially inflation-protected bonds), but before long investors will start looking for more return, and that means investing money in real businesses and people.

3) Media reports are uniformly and overwhelmingly focused on the negative, and not the positive news--and there is positive news out there, it's just hard to find. I take this as a sign that the mood can't get much worse from here.

Third, just as in the past couple economic slowdowns, all the money the Fed is pumping into the economy right now is likely to lead to a new bubble somewhere in a couple years. Don't believe me? Look at the pattern: the 1992 recession was arrested by easy money from the Fed, which contributed to the dot-com bubble. The 2002 recession was also marked by easy money from the Fed, and that helped pump up the real estate bubble.

This isn't necessarily a bad thing. Financial bubbles (despite the problems when they burst) have a number of desirable side-effects, not the least of which is driving a period of strong economic growth. Bubbles also tend to create massive investment in infrastructure which--even if uneconomical when built--lay the groundwork for future innovations and benefits. For example, a massive amount of fiber-optic capacity was built in the late 90's, far more than would be needed at the time. But the telecoms which lost their shirts on that fiber also created the conditions for cheap bandwidth today and made companies like YouTube possible.

For the most part, the excess housing built this decade won't disappear, and (as long as the population continues to grow) there will be families willing to buy or rent the homes for the right price.

What's The New Bubble?
If you think there's going to be a new financial bubble forming in the next few years, it's very useful to know where the bubble might form. Good candidates are industries or sectors where:

1) Fundamentals have changed significantly for the better recently, and are likely to remain favorable. This could be due to new technology, market conditions, or other circumstances.

2) Returns have been good.

3) There's an element of sexiness or the exotic to pique investors' interest.

The most obvious place is alternative energy: if you believe that oil is likely to remain around $100/barrel or higher for the indefinite future--and this seems a reasonable assumption--then the fundamentals for renewable energy are strong. Combine that with improving technology and dropping prices for renewable sources like wind and solar, and the sexiness of "green energy," and it looks almost irresistible.

What's more, if you believe that renewable energy will ultimately have to replace nearly all our fossil fuel consumption, there's enough demand for renewables to sustain industry-wide growth of 25% to 50% per year for decades.

First Draft of a Renewable Energy Portfolio
To test this investment thesis, I took a stab at building a model portfolio over the weekend. I started with a comprehensive list of alternative-energy related companies (which was hundreds) and applied these criteria:

1) The stock has to be listed on the NYSE or NASDAQ. No pink sheet stocks or bulletin board stocks; any company with serious prospects will have the resources to get listed on a "real" exchange. Also, no foreign exchanges, since those are harder for Americans to buy, and I'm not familiar with the foreign accounting and trading rules.

2) The company has to be primarily focused on alternative energy. This excludes companies like GE, which makes a lot of wind turbines, but makes most of its money elsewhere.

3) No biofuels, because I'm not convinced that biofuels make economic or environmental sense in the absence of government supports.

This left me with 14 companies, all but one of which make solar panels (the other company is a tiny manufacturer of wave power systems).

Also, because this is a hyper-growth industry, I weighted the model portfolio by revenue growth in dollars from 2006 to 2007. That eliminated two companies which actually shrank (one due to an accounting change which I didn't want to bother researching). I also applied a cap of 15% of the portfolio value to individual companies, to keep it from being too heavily weighted towards a couple big Chinese companies.

Of the twelve remaining companies, about 60% of the portfolio wound up in four big Chinese manufacturers of conventional (polysilicon) solar panels, and First Solar, the upstart thin film manufacturer, was another 13.5%.

Unfortunately, this has been a really bad week for my model solar portfolio: all but two of the companies are down for the week, and the portfolio as a whole is down 15%. Apparently one of the big Chinese companies lowered its forecasts because of cost and availability problems with polysilicon, and that pulled down the entire industry (even the companies not using polysilicon).

Volatility is to be expected in this sort of concentrated, speculative portfolio, but I'm really glad I didn't invest any actual dollars in it this week.

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