Recession-Proof Your Finances
Predicting a recession is like forecasting a storm -- it's difficult to know exactly when the first sprinkles will start, when the final drops will hit the pavement, and precisely what might happen in between. But like a storm that leaves damage in its wake, a recession can have a serious impact on your finances, including your investments, the value of your home, and the security of your job. So it's wise to be prepared, even when the forecast isn't clear.
Simply put, a recession describes an economy that's shrinking rather than growing. One barometer is the gross domestic product -- the total market value of the final goods and services produced in the U.S. When that drops for six straight months, many economists conclude that a recession has taken hold.
The GDP grew by an annual rate of just 0.6 percent in the fourth quarter of 2007, according to the Bureau of Economic Analysis. And many experts believe that it is sputtering even more in the first quarter of 2008 under the weight of downturns in the housing and financial sectors. Still, since the GDP grew by 4.9 percent in the third quarter of 2007, we've yet to hit the six-month stretch that some say signals a recession.
But that's just one indicator. Moody's Economy.com assembles a monthly "risk of recession" index based on eight factors, including the Standard and Poor's 500 Index, first-time unemployment claims, consumer confidence, and new housing permits. Are we in a recession? By February 2008, that index stood at 62 percent, up from 16 percent in May 2007. "It is no longer a question of if, but rather how severe the economic downturn will be," concludes Ryan Sweet, an economist at Moody's.
Citing soaring energy prices and a paltry rate of economic growth, Robert Parks, a finance professor at Pace University in New York, contends that a recession isn't merely possible -- it's already arrived. "A growth rate of 1 percent is pitifully poor, and the prospects don't look any better," he says. "The buying power of consumers has gone nowhere. We're in a recession right now."
While some analysts have been hesitant in labeling the current economic crisis as a recession, there's no question that these are rocky times for many. Consumers are feeling the pinch of rising prices for food and gasoline and of declining home values. The Federal Reserve is scrambling to keep the economy from stagnating (it cut rates six times between September 2007 and March 2008, when it bailed out financial giant Bear Stearns.) And the stock market remains wildly volatile. So it makes sense to shore up your financial defenses.
Following are four areas of your financial life -- investments, housing, borrowing, and employment -- that might be affected by an economic decline, along with measures you can take to help cushion the blow.
A recession can clearly have a short-term effect on stock prices. A look back at the recession that occurred between July 1990 and March 1991 offers ample evidence. According to Moody's, the S&P 500 fell from 356 to a low of 304 in October 1990. Then it started a steady climb, surging past 400 by the end of 1991.
Follow that chronological lead with your investments. If your goals are long-term -- say you're in your 40s and saving for retirement -- you have more than enough time to ride out any short-term price drops that might happen during a recession. To do that as comfortably as possible, take care to build a portfolio based on your goals and risk tolerance -- one that you're confident sticking with if the market turns south.
Charlie Massimo of CJM Fiscal Management, a financial-planning firm in Garden City, N.Y., recommends that you diversify your portfolio by investing in different asset classes that don't move in tandem. "Dissimilar price-movement diversification protects you from having all your investments go down at the same time," he says.
Here are some other approaches for helping you deal with recession-fueled market volatility:
Official recession or not, home sales have taken a beating of late, as they tend to do in a recession. The National Association of Realtors reported recently that, despite a slight monthly rise, home sales in February 2008 were still down 23.8 percent from the prior year. And home prices were also down: In February the national median existing-home price was $195,900, down 8.2 percent from a year earlier, when the average was $213,500.
Here are some survival strategies:
In recessionary periods, the silver lining for consumers is that interest rates often decline, making borrowing less expensive. That is entirely by design, says Sweet, the economist at Moody's.
During the 1990-91 recession, for example, the Federal Reserve gradually reduced the federal funds rate from 8 percent to 6 percent in an effort to ramp up the economy. "The reduction in short-term interest rates reduces the real cost of borrowing," notes Sweet. "This is important for stimulating economic growth, as lower interest rates entice consumers to take on additional debt to finance their consumption."
And the Fed has been on a rate-cutting spree lately. In late March, after six rate reductions since September, the federal funds rate was just 2.25 percent, down from 4.75 percent seven months earlier.
Lower rates present you with opportunities to reduce the cost of your debt:
As an alternative, fold the loans into refinancing your mortgage or into a home-equity loan (unlike consumer debt, the interest is tax-deductible up to certain limits). Keeping your debt level low is particularly important if there is any question about your job security.
An old joke says that a recession is when your neighbor loses his job; a depression is when you lose yours. But history shows that a recession's effect on employment is no laughing matter. For example, the unemployment rate rose from 5.5 percent in July 1990 to 6.8 percent in March 1991, putting roughly 1.66 million more Americans out of work during that recession.
Recently the current employment picture became bleaker. The U.S. Department of Labor estimated that the country lost 63,000 jobs in February 2008, the second straight monthly decrease.
Here are some suggestions for hedging your employment bets: