Is It Time To Mention the R Word

The stock markets are stormy, and recent economic data adds more clouds on the investing landscape. The one clear part of this picture is that the economy is slowing. But it is time to mention the “R” word?

We’re talking about recession — in other words, is this economic boom going to end with a hard landing or a soft one? And what should investors do in either case?

Some Cassandras see a full-scale economic recession, or as defined by the National Bureau of Economic Research “a period of decline in total output, income, employment and trade, usually lasting from six months to a year,” as a distinct possibility in 2001. Even the usually calm Fed Chairman Alan Greenspan said in a recent speech that the combination of high energy prices, falling stock prices and rising interest rates for private borrowers might slow the pace of economic growth too much. That has fueled hopes that the Federal Reserve will ease interest rates early next year to avert a recession.

Warning Signs

Many of the key economic stumbling blocks that usually preclude a recession are upon us: falling stock prices, a drop in consumer confidence and higher unemployment claims (although unemployment is still at very low levels). What’s more, edginess in both the stock and the bond markets is making it hard for companies to raise funds for investment or expansion plans, and making consumers less inclined to spend money.

Overseas concerns haven’t helped much, either. The U.S. trade deficit is widening. Many experts are concerned that some of the foreign money that has poured into the U.S. equity markets during the past few years will get pulled out and thrown into European markets, which stand to gain from a potential euro recovery. And turmoil in the Middle East has been a catalyst for escalating U.S. energy prices.

Still, the U.S. economy is not about to go into full-scale recession, says Michael Boldin, director of real-time economics at Economy.com. “Half the time a downturn for the leading economic indicators is an early sign of a recession, but I don’t think the odds are for that this time.”

Boldin’s sense is that there are plenty of areas of strength in the U.S. economy, such as the financial services sector, which he says is still strong. Stock prices are down, but still high relative to fundamentals he says. “Before most recessions we have a weak financial situation followed by some shock, such as in the late ’70s when there was consumer confidence took a dive, oil prices rose and the Fed was fighting inflation.”

The Levy Institute Forecasting Center, which analyzes and forecasts the U.S. economy, recently published a report that says there is a 70% probability of a recession beginning in the next 12 months, and it is likely to begin in the first half of 2001. The thinking is the three financial phenomena that were key to the recent historic economic boom — unrestrained debt creation, soaring stock prices and abundant international liquidity — are disappearing, and so the question is not what will trigger a recession but what can stop the recessionary process already under way.

Srinivas Thiruvadanthai, a resident scholar at the Levy Institute, says that the idea of an economic slowdown without a recession is a fallacy, because with unemployment still very low, inflationary pressures will not go away, and so the Federal Reserve will not ease interest rates. “So the current conditions affecting the economy and the stock market will not retreat, so we don’t see the economy achieving a soft landing.”

Weather the Uncertainty

No one can say for sure what will happen in 2001. But judging from the leading economic indicators, a long-term economic slowdown is in place, and that could have a negative effect on your investments, says David Yeske, a financial planner at Yeske & Co. in San Francisco. “Our assessment is that the economy is slowing, but we’re not acting on that in any way, as being able to see the start of a change in the economy does not necessarily mean that you can make the right short-term decisions,” he says.

If you’re saving for retirement or building a nest egg, the best strategy is to weather the storm, says Yeske. Reconfiguring your portfolio after bad economic news is not a good idea, as it’s difficult to predict how the markets will react. The stock markets are the best measure of how the economy is doing, as it tends to move ahead of most other economic data. “Trying to make investment decisions based on visible changes in the real economy is a rather futile exercise,” he says. By the time economic data has signaled a change, the market will have already adjusted.

Important indications of economic turmoil include rising unemployment, stagnant corporate earnings and a drop in gross domestic product, or GDP, which shows the total value of all goods and services produced within a country, Yeske says. GDP is the broadest measure of an economy’s health and was recently revised down to 2.4 % from the 2.7 % annualized growth originally estimated for the third quarter, the slowest pace in four years. “It’s an even stronger indication of slowdown in the third quarter,” says Brent Moulton, associate director for national economic accounts at the Bureau of Labor Statistics at the Department of Commerce.

Still, while there’s not a lot you can do in the short term, by looking six months down the road investors can do a lot to make sure their portfolios are in good shape, says Stephen Barnes, a portfolio manager at Barnes Investment Advisory in Phoenix. “We’re preparing to take advantage of a situation where companies’ stocks are at beaten-down levels, so we are taking advantage of possible opportunities,” he says.

In such a climate, Barnes still counsels holding firm on your main investments. “I firmly believe that investors make more money sitting on their hands than not, and that’s harder these days will all the white noise in the markets,” he says. “The reality is that we are going from a stupendous economy to a good economy, and so that should temper the running from stocks.”