One of my 10 Reasons the Economy Will NOT Recover in 2010 is that consumers are still afraid to spend.

Wall Street doesn’t get this, and bullish analysts do not seem to understand the cocooning effect, which simply means that people are staying home more in an attempt to save money.

But their obliviousness can lead us to some great long and short plays.

Cocooning is a very broad-based phenomenon. As people continue to rein in their spending, they are “trading down” — from expensive restaurants to cheap ones or dinner at home, from a night out on the town to the night in with a Netflix DVD (or download), from booking a room at the Hyatt to a stay at the Comfort Inn.

Belt-Tightening Will Continue to Hurt Restaurants

Let’s focus on restaurants for a moment.

Investors’ current passion for restaurant stocks is misguided, and these stocks are starting to roll over, which is why I want you to take a look at them now.

Sure, compared to GM or Citigroup (C) restaurants are in great shape. That’s because they’re typically very well-managed — it is a miserably difficult business, and if you don’t manage your stores well, you’re history. (Maybe the CEO of DineEquity (DIN) could turn Citigroup around.) And ChangeWave Research surveys say restaurant spending has stabilized.

But none of this means people will be heading out to restaurants in droves again.

For most people, restaurants are a luxury, and these are frugal times. (Unfortunately my kids, who are painfully attached to sushi, don’t seem to get this, although I can usually talk them into the wing joint next door.)

Christmas and Chanukah are around the corner. But, like last year, we’ll be seeing smaller or non-existent holiday parties due to budget cutbacks. People will be saving their money to buy more gifts for the kids or a train ticket for Grandma. That means going out to eat less often.

When people do dine out, they will trade down from upscale restaurants to chains, and from relatively expensive chains like PF Chang’s China Bistro (PFCB) and the Cheesecake Factory (CAKE) to T.G.I. Friday’s. And they’ll pass on the pre-dinner cocktails and share a dessert, if they order one at all.

Take a Walk to Burger King

This all means that it’s time to short this sector by buying put options on restaurant stocks. (See why put options are The Best Way to Short Stocks.)

Peter Lynch had his “take a walk down Main Street” style of investing, so I’m going to call this my “take a walk to Burger King” approach. Go eat at the chains, check them out, see how many people are there, whether they are using coupons and so on.

And look at chains with a lot of debt, such as DineEquity (DIN) or Ruby Tuesday (RT).

When interest rates go up, their cashflow is going to take a serious hit, but this could take a while, so consider longer-term puts.

Recession Winners

Just because people are spending less doesn’t mean you can’t make money on the long side.

Netflix (NFLX) comes to mind first. It’s growing its business and will certainly benefit from the cocooning phenomenon.

The stock looks like a keeper, but it’s a little on the expensive side. However, you can play it for less by purchasing longer-term call options instead. Or, with all the recent volatility, you could try to get the stock at a better price by selling put options and waiting for this crazy market to have a bad day.

I also like PetMeds Express (PETS). The stock was recently crushed due to a miss of whisper earnings estimates, but the company is profitable and growing, and people don’t kill their pets during a recession.

So consider buying PETS at this reduced price, or think about buying some longer-term calls.

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