Illustration by Jason Lee
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How to Ride Out a Recession
By Walecia Konrad, March & April 2008
Bad signs in the economy make it easy to worry, but experts say the sky isn’t falling—yet. This is what you can do to protect yourself
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Slumping housing. Tightening credit. Shaky stocks. Spiking oil prices. Whatever adjectives economists attach to current conditions, the forecast seems to be the same: a financial storm is threatening our pocketbooks and savings. Even the R word—recession—is getting airtime.
True, we’ve been here before. Through terrorism, war, even Katrina, the economy has shown its resilience, says Lakshman Achuthan, managing director of the Economic Cycle Research Institute, one of the nation’s leading forecasters. “A shock alone won’t cause a recession if the economy is otherwise strong,” he notes. But here’s the rub: “With the housing slowdown and subprime mess, this is the first time in a long time that we’ve had the combination of a big shock and an economy showing real signs of weakness. That combination is a recipe for recession.”
What changed? In brief, your home lost value. The air began escaping from the housing-price bubble in 2006, pressuring millions of homeowners who’d wagered that rising real estate or their own income gains would keep them ahead of their precariously high debts. Then it turned out that mortgage lenders had encouraged too many of those bad bets—and that still more financial institutions owned a piece of the problem because they’d purchased securities based on these risky loans. By last July, the ripple effects from mortgage losses hit big banks, and the stock market began to seesaw downward.
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As of December, Achuthan wasn’t actually forecasting a recession—a shrinking of the economy—just slower growth. But the possibility can’t be dismissed. Morgan Stanley investment strategist David Darst pegs the chance of recession at 50 to 60 percent. Even former Federal Reserve Board chairman Alan Greenspan said at year’s end that the odds the economy will tip into recession are growing.
Such talk matters. The Consumer Confidence Index has taken a nosedive since July, and the drumbeat of doubt can make all but the coolest investor jittery. “The psychological impact of all this bad news is part of the reason we’re in a slowdown,” Achuthan observes.
What’s a person to do? Try to keep your head. “The economy is a series of ups and downs,” says Milton Ezrati, senior economist at mutual fund firm Lord Abbett. “Weathering each storm with smarts and a sense of calm is the best advice at any time.”
To help you do just that, we gathered expert advice on handling turbulent times ahead in three significant areas.
Home Values
The story so far Overall housing prices peaked in 2006 and have declined almost 7 percent since, according to the S&P/Case-Shiller Home Price Indices. Foreclosures were at an all-time high last year, rising to nearly 2 million from 1.2 million in 2006, the marketplace RealtyTrac reports.
How bad could things get? A big wave of adjustable-rate mortgage resets hits in the first half of 2008. Robert Shiller, the Yale economics professor behind the Case-Shiller indices, says it’s possible housing prices will decline 30 percent from their peak. That’s as much as they fell from 1925 to 1933, the low point of the Great Depression. Others predict a 15 percent drop.
Conventional wisdom Ride it out. “If you can stay put until the storm passes, the market will be positioned for a healthy rebound,” says Achuthan. If you must move, try to sell your property before you buy a new home, so you don’t get caught short. And, yes, fixed-rate mortgages are the only way to go.
The new wrinkle Renters in a position to buy may find bargains—including their current home. That’s because investment homes aren’t in line for breaks taking shape for some overextended homeowners, so your landlord might sell to you on the cheap. Less happily, if you aren’t buying and your landlord is facing foreclosure, you may have to act quickly to avoid eviction (laws vary by state). Keep paying rent and negotiate with the lender to stay, at least for a while.
The Cost of Borrowing
The story so far The Federal Reserve cut its loan rates to banks three times last fall, but with lenders still taking losses—for instance, auto-loan delinquencies among top-rated borrowers jumped the most in eight years in September—banks are wary.
How bad could things get? Financial institutions could cut lending by as much as $2 trillion before the subprime mess is cleaned up, according to Goldman Sachs. “Consumer interest rates will go up even as the Fed lowers,” says Morgan Stanley’s Darst. “The bond market is expressing skepticism, saying there will be recession.”
Conventional wisdom When it’s a bad time to borrow, living within your means is a priority. Put away the plastic and pay with cash.
The new wrinkle An economic slowdown can put the breaks on inflation, but in some sectors that older Americans care most about—insurance, health care—price rises have defied overall conditions, notes James B. Kruzan, president of Kaydan Group in Clarkston, Michigan, an investment advisory firm. “Plan carefully for these expenditures,” he warns.
Investments
The story so far By November, U.S. stocks had slipped 10 percent from their peak—that’s called a “correction” on ever-hopeful Wall Street.
How bad could things get? Stocks could lose another 10 percent or more by June, says Achuthan, as financial companies take losses. “Financials are the bodyguards of the market,” says Darst. “When bodyguards are getting shot at, you know there’s trouble.”
Conventional wisdom First, reduce risk. Move 10 percent of the stock portion of your savings into fixed-income vehicles such as money market accounts, Darst counsels. “You’ll sleep much better, and if recession doesn’t come, you’ll have money to reinvest.” Second, stay diversified. It’s the best move in any market. That means stocks and bonds, both domestic and foreign. (See “Spreading Your Bets,” below, for details.)
The new wrinkle There is no new wrinkle, despite what you’ll hear about the smart money going to gold or timber or India or the latest financial product supposedly devised to slice and dice risk out of existence. “Today’s hot thing is almost always tomorrow’s loser,” says Kruzan. “It pays to know what you don’t know.”
Spreading Your Bets
To shield your savings from market turmoil, it’s best to invest across the board. That means money markets, bonds, and stocks of every type.
With bonds, try a total-bond-market fund, says Tim Johnson, a financial planner at Lincoln Financial Network. With its variety of maturities and credit risks, you’ll be cushioned against the hazards of, say, too many mortgage-backed securities. Bond funds labeled “total,” “diversified,” or “aggregate” are also common in 401(k) plans.
With stocks, you’re investing for the long term, so “make sure you’re invested in every type of investment style,” says financial planner James B. Kruzan.
What’s investment style? Consider the ticktacktoe board, below, that funds monitor Morningstar has made famous. The nine boxes sort mutual funds by the market value (large, midsize, or small) of the companies whose stocks they hold and the approach to investing the fund manager takes. Looking for underrated stocks is called value investing, while trying to buy stocks primed for takeoff is growth investing. Funds that blend growth and value occupy the center column.
The easiest way to invest, says Kruzan, is to choose one broad index fund of each size—a large-company (large-cap) fund based on the S&P 500 Index, a mid-cap fund that tracks the S&P MidCap 400, and a small-cap fund that follows the Russell 2000 Index. A good international index to track is Morgan Stanley Capital International’s Europe, Australasia, and Far East Index.
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