The U.S. economy has likely been contracting in recent months, and there are few signs of any bright spots on the near-term horizon. Consumer spending has been hit by weaker labor markets, tighter credit, falling home prices, and some of the weakest consumer confidence readings in decades. Manufacturing activity has held up relatively well, led by firms tied into international markets. But looking to international export growth as a bailout for any significant developing recession in the United States may be overoptimistic in light of past experience.

Business fixed investment spending has been another source of relative strength in the manufacturing sector, but business confidence has been waning along with consumers in recent months. In past recessions, business investment spending has shown that it can turn south on a dime, one reason for a deservedly procyclical reputation. Tighter lending standards also seem likely to take a bigger bite out of this source of growth.

Consumers and business decision-makers aren’t the only ones losing confidence out there. Securities analysts may be joining the party as well. A small but growing number of analysts have been cutting their sales and earnings forecasts for the next year or two, citing weaker economic conditions. At the outset of 2008, a compilation of analyst projections for earnings for the S&P 500 companies indicated a 16% increase for the year. That gain has since been shaved to about 14%, and a growing number of observers have speculated that this expected increase is likely overoptimistic in light of economic trends.

Corporate earnings are driven by both company performance and the overall economic environment. It isn’t rocket science. Earnings on the S&P 500 tend to rise faster in periods of faster economic growth and to decline in recessions. Our last recession in the United States lasted from March to November 2001. For 2001 as a whole, the earnings per share for all the companies in the S&P 500 declined 15%. The previous recession lasted from July 1990 to March 1991. Earnings per share on the S&P 500 fell 10% in 1990 and 12% in 1991.

Should Selling Be on Your Mind?
Today, as a growing number of observers concede that we have entered another recession, expectations for earnings in the next year have been on the wane as well. But selling stocks simply because earnings estimates are falling isn’t necessarily the best way to make money in the long run. For that matter, a slowing economy isn’t necessarily a reason to hold back on buying, either.

The three things that matter include:

• The price of the stock,
• The company the stock represents,
  …and, taking these first two together,
• The price of the company’s stock, relative to its ability to generate free cash flow in the future.

Stock prices tend to decline heading into recessions, and they tend to weaken further in the early stages of recessions as well. But generalized concern about generalized economic slowing can lead to situations where the stock prices for some individual companies fall significantly below their fair value. In environments like these, when people are losing jobs and many stock prices are going down because other people are selling them, it is hard to be a hero. But here’s a simplified example on how heroism can pay off for patient, good, and sometimes lucky investors.

Let’s take a time machine back to 1990. As the year progresses, the economy begins slowing. Manufacturing and construction sectors usually take it on the chin in a developing overall slowdown, and it’s no exception this time around. Let’s say you are just out of college, you just got married, you and your spouse are expecting twins, your new job is looking a little tenuous, and your savings are in only one stock. Last year, you bought 200 shares of an industrial distributor called  Fastenal (FAST FAST), a company that sells nuts and bolts.

Recessions are rough on nuts and bolts companies. Wall Street earnings estimates for industrial distributors have been coming down sharply in recent months. Fastenal’s common stock has fallen by a third in the six months ended in October 1990. Time to sell?

Hope not. Hindsight is easy–to be sure–but it was time to buy, if anything, on Fastenal. Adjusted for splits and dividends, Fastenal’s common stock rose from less than a buck in late 1990 to $46 in early 2008. Granted, this is a remarkable success story plucked out of a hat in hindsight. But there’s a lesson here too–one that we think highlights the value of patience rooted by discipline in a discounted cash flow, value-oriented investment framework.

Keeping Perspective
What’s the lesson? Don’t discount the future too cheaply. Don’t focus too closely on near-term expectations if you are investing for objectives 10 or 20 years down the road. We live in an imperfect world, and it can be easy to get jaded or cynical about how it fails to meet our hopes. Stay cynical, but keep the faith. We live in a resilient world, and markets, for all their shackles and subsidies, tend to reward the fundamental winners in the long run.

How does flowery pep talk like this translate into here-and-now decisions? Don’t focus too closely on near-term price/earnings ratio when earnings are declining and P/Es are otherwise under pressure from reduced investor confidence. Our discounted cash-flow framework isn’t perfect, but it does help illuminate the value of longer-term thinking. If reduced revenue and margin expectations cut into a given firm’s earnings projections for 2008 and 2009, for example, a P/E on near-term earnings expectations may look high relative to an underlying longer-term expected growth rate.

In a discounted cash-flow analysis, reduced expectations for cash-flow growth in the next year or two will reduce a fair value estimate. But the majority of the value in our fair value estimates arises from discounted expectations for cash flow three years down the road and beyond. In recent months, we’ve been seeing prices for many wide-moat stocks falling below fair value estimates, and we think the market has been focused too closely on the deterioration in economic conditions.

There is at least one important caveat to consider in our current economic environment. If inflation keeps rising, all bets are off. I’m not ready to take off my own bets yet, but I’m concerned.

Bill Bergman is a senior analyst with Morningstar.