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Five Things You Need to Know: The Bear Case


During a recession, beer and liquor is always the last to go.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. The Bear Case

Ok, here's the bear case in a nutshell.

The U.S. recovery following the Internet bubble was largely led by a very profitable banking industry able to provide large amounts of credit to willing borrowers from top to bottom in the economy.

Although the vast majority of banks as recently as last June had what appeared to be strong capital positions, unexpected losses that began with subprime mortgages, and a rapid increase in risk aversion, have forced financial institutions to take onto their own balance sheets the assets of many of the off-balance-sheet investment vehicles they had sponsored. This has created a spiral of increased risk aversion as bank balance sheets have swollen.

Banks have been forced to become more protective of their liquidity and thus less willing to provide credit to other market participants, including other banks. Moreover, this risk aversion has spread to corporations and households as lending even to those sectors has become more restrictive.

The net result is a sharp slowdown in the velocity of money in the economy. The subprime mortgage market has virtually shut down and foreclosures are adding to an already elevated inventory of unsold homes. Meanwhile, widening spreads on jumbo mortgage loans has further reduced demand for housing which will likely cause further cuts in homebuilding and related activities.

Now, we are seeing conditions in the labor market soften as payroll employment declined by an estimated 17,000 jobs in January. Softening employment along with high energy prices, lower stock market prices and declining home values are now weighing on consumer spending, which is further contributing to the slowdown in economic growth.

At this point you are probably tired of the negativity, right? "C'mon, Kevin, how can you be so bearish?!"

Well, it's not me.

Those comments are simply a summary of Federal Reserve Chairman Ben Bernanke's testimony this morning before the Senate Committee on Banking, Housing, and Urban Affairs. Bernanke. That permabear!

2. Bernanke Testimony Leaves Fans Unconvinced

3. High and Low

A review of a handful of earnings conference calls reveals why the ongoing debate over whether we are headed for, or already in, a recession exists. It's about Tengoku to jigoku, or High and Low, heaven and hell.

First, PF Chang's (PFCB) reported earnings yesterday and, as is de riguer for consumer discretionary companies these days, noted the headwinds they are facing due to the macro environment.

"Candidly, it looks like this [challenging economic conditions] will be with us for at least the balance of the year as there are no short-term solutions to the issues the consumer faces regarding discretionary spending." Richard L. Federico, Chairman and Chief Executive Officer said.

That's almost boilerplate language these days. But these next comments from PFCB President Robert Vivian are not strictly boilerplate and show us what the slowdown means in real dollar terms:

"The fact of the matter is that we – if you align our tickets into price buckets, if you will - we continue to see leakage at the lower price buckets, and we continue to see gains at the higher price buckets," Vivian said. "Unfortunately, it's consistent with the patterns that we've seen for the last year and a half and it's consistent with patterns that we've seen in the past in prior lives during slowing economic or recessionary times, where you simply lose your lower end guest," he added. "Frankly, in our opinion, there's not a lot you can do right now to regain those guests."

We also checked out the Denny's (DENN) call, not because it's a particularly important stock, but because the company's demographic falls below the PFCB demographic in terms of income.

"Denny's customers like many others have been adjusting to economic difficulties and have been reevaluating their discretionary spending," Nelson J. Marchioli, President and Chief Executive Officer said on the company's call. "They are forced to make budgetary or value driven choices and dining out appears to one of the first expenditures to be impacted."

Finally, the PFCB comments noting the dichotomy between the high and low customers were echoed by Jerry Throgmartin, Chairman and CEO of consumer appliances and electronics retailer HH Gregg (HGG).

"What you're seeing is probably not unlike what the general economy is seeing. You're seeing the consumer that is entering the market, early entry models, midline models, suffering a lot more erosion than the consumer at the higher end," Throgmartin said. "We are seeing units slowdown a lot more significantly at the entry level and midlevel price points, which we're attributing to some of the consumer conditions [affecting those consumers] that would be most likely to buy at those price points."

As an interesting sidebar, the image used here is from the Akira Kurosawa film, High and Low. In the film a wealthy man mortgages everything he has to stage a leveraged buyout of the firm at which he is an executive. A kidnapping occurs. Naturally, class envy is at the core of the issues Kurosawa's film explores; an appropriate image for what we are seeing today.

4. What's On the Other Side?

Looking at the dichotomy between high and low side consumers highlighted in today's Number 3, consider what is on the other side of the negativity.

Take a close look at the companies focusing on the very bottom of the consumer credit spectrum. These companies are likely to see an increase in the demand for their services.

Pressure on subprime homeowners and consumers is well-documented, but some companies thrive by buying delinquent debt at a deep discount and chasing down borrowers to make payments. Its an ugly business and one wrought with employee turnover, but recent action in the stocks indicates this segment may be a refuge from the deluge.

Asset Acceptance Capital (AACC) buys defaulted or charged off debt from consumer credit originators in the U.S. and is trading higher today, up 4.41% to $10.42.

Portfolio Recovery Associates (PRAA) provides outsourcing services to receivables managers in addition to purchasing and managed their own non-performing assets. Shares are up 0.43% this morning to $34.92.

CompuCredit Corp (CCRT) is a subprime consumer lender and invests in charged off debt -- trading up 3.47% to $11.33.

Each of these companies has seen its shares come down considerably since the beginning of the credit crunch but may be some of the first to pick up the pieces.

5. Liquor & Beer, Always the Last to Go

Recessionary slowdowns don't typically happen all at once or appear as linear as a chain of dominoes falling. There are fits and starts . One are that always seems to be the last to fall is liquor and beer.

Last week we noted that Fortune Brands (FO) insisted they were not seeing consumers trade down from ultra-premium spirits to lower-priced liquors. Earlier this week Molson Coors (TAP) CEO Leo Kiely said the company is not seeing any sign that consumers are trading down from expensive beers to less expensive brands.

"So far, so good. And I'd expect beer will weather this pretty darn well," Kiely told Reuters.

Seems during a recession, beer and liquor is always the last to go.

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