On the heels of the Royal Bank of Scotland warning of an impeding stock market crash, Warren Buffet commented yesterday that the U.S. economy is in a recession and getting worse. The economy is under at least three distinct pressures: collapse of the real estate market in the United States, the financial industry unwilling to lend money and high fuel and food costs. You have the worse of three worlds: a slow-down of consumption in a consumption based economy, lack of capital to fuel business growth and productivity and out of control expenses on essential items.

Before you head to your bomb shelter and hunker down for a few years, there are a few things to remember:

1. There is a people shortage in all sectors. This isn’t like the 70’s or the early 90’s where there was a large supply of labor relative to demand. Everybody needs people. Remember the hue and cry about there being too many lawyers (please no lawyer jokes, I have heard them all)? My friend can’t hire a junior lawyer to save his life; there are none available. If you live in Alberta, you know full well the labor shortages everywhere (Tim Hortons in Alberta are known not to open for lack of employees). The U.S. unemployment rate is at 5.5% as of May, 2008.  I remember my first year economics professor telling me (before the internet, tech bubbles and globalization) that a 5% unemployment rate was the perfect unemployment rate (not too hot and not too cold). Despite all the rhetoric about outsourcing and the collapse of traditional manufacturing (without looking at the growth of non-unionized and high tech manufacturing) demographically, the work-force needs people. The more skilled, the better. But, North America needs bodies because there are more people retiring than we can bring into the work-force (and, hence, why choking off immigration may win political points but is economically unviable especially if government promotes a consumption based economy).
2. …but, there’s clearly something not right with the financial system. It is pretty clear with hind-sight what the banks did with all the money the federal banks pumped into the system; they used it to prop up their balance sheet and didn’t lend it out. Easy access to capital is the foundation of business growth. By choking off access, the banks are slowing the economy down. This won’t be felt until later this year and 2009 but it works its way through the system.
3. The American election is sugar-coating the real problems. America has a lame-duck President until November (and, realistically, 2009) and, given it is election season, a lot of issues are being glossed over. There’s been a lot of policies which got us here (the deductibility of interest payments on mortgages, the subsidization of a bio-fuel industry, the propping up of the financial industry rather than the defense of the U.S. dollar) which cannot be examined in-depth with quick sound-bite quotes which all elections are built in. 2008 is a stand-still year because of that reason and we seem to be living in a never-never land.

Do I think the economy will get worse? Yes. A crash? Probably not. We increasingly live in “I want it now and let’s forget tomorrow” society, governments will do anything to prop up the economy for a crash regardless of the long-term consequences. The real crash will be driven by demographics in about 5 years.

However, some things to note in the realm of personal finance:

1. It is time to get back to fundamentals:My banker friend says it best- “when there’s more junk than common sense on the street, its the end of the cycle.” I am seeing a lot of strange stuff being sold: exchange traded funds hedged to markets, mutual funds disguised as exchanged traded funds (with the requisite high MER’s), limited partnership units investing in treasure ships and whatnot. WHAT?!? Stick to the bread and butter products: government issued bonds, blue-chip/dividend paying stocks and real estate based on positive cash flow production. Things your grand-parents bought when they were your age; there’s a reason why they keep selling it now. It works. BORING EQUALS GOOD in investing (and in life if you really think about it).
2. Forget appreciation, focus on cash flow. I have mentioned before I sometimes vet deals for a friend of mine who lends money out. Here are his instructions- I will not lend on potential or appreciation. Lend on cash flow only. My friend is not dumb. The past 5 years were all about looking for the home-run appreciation stock or real estate. Those days are, alas, done. The easy money is gone. Anything you invest in, look for cash flow first then appreciation second. Cash flow gives you a margin of safety in bad times. Look for stocks that pay a dividend (which it can maintain), real estate with positive cash flow or businesses that are cash rich.
3. Better get your credit now. HSBC turned off the taps on all new real estate lending recently. Globally. Banks and lenders are systemically shutting off one risky loan portfolio after another. If you have shaky credit, best to secure some now. If you have good credit, ask for an extension before the pool of money to be lent out by banks shrinks.
4. Asset allocation is your friend. Balance your portfolio with the right mix of cash, fixed income and stocks and you can weather the worse. Never forget that cash is an asset allocation category. The pros are not fully invested and neither should you.
5. The consumer is in control. Remember the days you could not find a trades person, a car on sale or an affordable home? Those days are gone. The consumer has the power so use it to hunt out the best deals.

..and, above all, stay positive.