We're Nowhere Near a Recession, but ...

John Waggoner, USA TODAY
Fri Oct 14,10:03 AM ET

Pimco's Bill Gross says there's about a 50-50 chance of a recession next year. If he's right, then you can take steps now to shore up your finances and your portfolio.

The shorthand definition of recession is two consecutive quarters of declining gross domestic product. In reality, a recession is more than just two bum quarters. "It can't just smell like a recession - it has to smell, look and taste like one," says Ken Goldstein, economist at The Conference Board's ( http://www.conference-board.org/ ) Bureau of Economic Analysis says GDP increased at a 3.3% annual clip from April through June 2005. The Conference Board's index of coincident economic indicators rose in August, the most recent reading. Coincident indicators show what the economy is doing now.

But the future isn't looking bright. The Conference Board's leading indicators, which try to show what will happen in the future, declined in July and August. It's a good bet they will have fallen in September, too, Goldstein says. "To the average guy in the street, come the holiday season, it could feel like a recession," he says.

Lower consumer confidence is one reason the leading indicators fell. Consumer confidence in September took its biggest one-month plunge since 1978, according to the University of Michigan. Big drops like that are often associated with recessions. Two-thirds of all consumers surveyed expected bad times ahead, and half expected higher unemployment.

Most expected higher interest rates, which is where Bill Gross comes in again. "Higher energy costs plus higher interest rates increase the risk of recession," Gross says. Oil prices, although down from their post-Katrina peak, are up 45% from the beginning of the year. The Federal Reserve ( http://www.federalreserve.gov/ ) has raised its key overnight fed funds rate 11 times since June 2004, to 3.75%. Gross thinks more increases are on the way.

One reason the Fed is raising rates, Gross argues, is to deflate the housing bubble. If mortgage rates follow the Fed's cue, fewer potential buyers will qualify for mortgages. But deflating a bubble gently isn't easy, particularly with crumbling consumer confidence and soaring energy prices. "If housing cracks and falls hard, we've got a recession," Gross says.

Chart of Real Estate Loans at All Commercial Banks:
http://research.stlouisfed.org/fred2/series/REALLN/100/Max

You can't really get out of the way of a recession, so your best bet is to prepare for it. The best two recession-proofing moves for your personal finances:

•Pay off your credit card debt. This is always a good idea, but if you lose your job, you'll have one less bill to pay - and a source of last-ditch emergency cash.

•Increase your cash. Financial planners recommend that you keep enough cash in money funds or bank CDs to pay three to six months' worth of bills. That's an enormous amount of cash, and probably more than you want. But it's good to increase your liquid assets if you feel your job is in danger.

Your portfolio will need some rearranging, too, and adding cash is a good idea. Cash not only cushions downturns in the stock market but gives you a buying reserve when the economy turns up again. You can find six-month CDs that yield more than 4% - and rates will likely be higher in six months.

If you invest in bonds, you should avoid junk-bond funds. These invest in high-yielding bonds issued by companies with shaky credit ratings. These are exactly the kind of companies that default on bonds in a recession. "It's not a great time for high yield," Gross says.

Instead, look for funds that invest in short-term bonds issued by rock-solid companies. Long-term bond prices get whacked when interest rates rise.

Traditionally, food and medical stocks fare best in a recession: People still have to eat and stop coughing in hard times. But most stocks get hurt in a slowdown. Your best investment now might be a stock fund with lots of cash. Five of the top performers are in the chart. They can help improve your odds of good returns if the economy rolls snake eyes.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com