By Paul J. Lim,
(Money Magazine) -- The great debate on Wall Street is whether the recovery that spurred stock prices to nearly double between March 2009 and April 2010 is about to be snuffed out. The evidence for a "double dip" recession: Europe's economy is teetering; federal stimulus that propped up the credit and housing markets is nearly exhausted; retail sales and manufacturing are declining again.
Plus, if the old saw is true that the stock market is a predictor of the economy six to nine months down the road, then look out. Stock prices have tumbled around 10% since late April and investor pessimism, by one measure, has fallen to lows not seen since 1987.
"You can't deny that there are some added risks of a double dip," says Jeremy DeGroot, chief investment officer for advisory firm Litman Gregory.
But before you start making major moves in your portfolio in anticipation of another slump, some perspective is in order.
For starters, actual double dips are rare. There have been three since 1913, the last in 1981.
What's common, on the other hand, is for recoveries to hit a major rough patch after the economy bounces off its lows. Nine of the 10 recoveries since 1949 hit a speed bump within about 10 months of the rebound, marked by dramatic drops in factory activity, consumer confidence, and stock prices. Sound familiar?
"These soft spots tend to last for several quarters," says Jeffrey Kleintop, chief market strategist for research firm LPL Financial, as government stimulus efforts fade and private-sector growth slowly takes over as the economy's driver.
In a way, though, it's moot whether the market is right in forecasting another recession. The economic expansion is clearly slowing. Economists have begun ratcheting down their expectations for gross domestic product growth from around 3.5% for 2010 to 3.1% -- and 2.7% in 2011.
So what macro effects will the slowdown have, and what actions, if any, should you take with your investments in response? Here are the three big issues to consider.
Consumers will struggle
Even if another recession isn't in the cards, a slower expansion means companies are less likely to get back into hiring mode quickly. That's likely to keep unemployment high and wage growth low, which doesn't bode well for consumer spending.
What you can do: Avoid companies that make consumer goods other than necessities. (Think about what you see in Wal-Mart's aisles rather than at Tiffany.)
This doesn't mean you should avoid economically sensitive areas of the market, though. For example, many money managers say technology stocks, which are typically vulnerable in a double dip, are shielded this time around by a software-upgrade cycle driven by business, not consumer, spending.
Inflation fears will abate
Earlier this year, economists and money managers expected the economy to pick up steam, leading quickly to higher interest rates and inflation, which threaten bonds. That's why Money has advised cutting your Treasury bond stake.
In light of the recent slowdown, that call turned out to be premature. With the economy in a soft patch, inflation fears have been put on the back burner, says Jeremy Grantham, chief investment strategist for the asset manager GMO.
What you can do: Grantham, who was one of the few people in the late '90s to predict that stocks would tread water over the following 10 years, thinks slow growth and deflation fears will translate into another tough stretch for the broad market.
However, this long-term bear has surprisingly high hopes for high-quality U.S. stocks, which have been overlooked for years and are considered cheap. He thinks the bluest of blue chips could return more than 7% a year for the next seven years. That means stocks such as Johnson & Johnson (JNJ, Fortune 500) and mutual funds like Jensen (JENSX) could do quite well.
Another strategy: Seek out firms that don't depend on a fast-growing economy, says Money's stock strategist Pat Dorsey.
The bear may be back
While a second recession is unlikely, "the odds that the S&P 500 will slip into a new bear market are growing," says Sam Stovall, S&P's chief investment strategist.
But whether or not stocks cross the 20% down threshold that marks a new bear doesn't really matter. What's more important is how stocks do afterward. And a growing number of market strategists note that investor sentiment cratered especially quickly in the spring and early summer; historically that's been a good sign for stock performance six months to a year later.
What you can do: It may be time to modestly trim your exposure to equities in the short term -- say by five to 10 percentage points. "Given the headwinds to growth, our view is that stocks at their current valuations are not compensating you with as much expected returns," says DeGroot of Litman Gregory.
If you haven't rebalanced in more than a year, you'll want to take this step; a 60% stock -- 40% bond/ cash portfolio has morphed into a 70% stock -- 30% bond/cash portfolio since March 2009.
Since the bond bubble hasn't burst yet, Treasuries are still historically expensive. So move that money into cash, says Stovall, which will allow you to shop for stocks at lower prices later. If you'd prefer to stay fully invested rather than trying a bit of market timing, check out the investment bargains highlighted in, "10 ways to make real money again."