A double dip would also lead businesses to further cut their labor force. The already staggering unemployment rate would again increase. That could be the last straw on the camel's back. Or if not that, another price plunge in the housing market. The housing bust that started in late 2006 is already the worst on record (even worse than that of the Great Depression), and another downward spiral would mean that more precarious mortgage-based loans could default. The banks holding the mortgages would have to add further bad debt to their off-balance-sheet inventory. The banks have so far been able to hide these loans, but a further decline in the housing sector would force them to start reconciling the bad debt, and that would surely lead to another collapse in this sector.
Thus, it is vital for us to answer the central question regarding this stage of the recovery. If the NBER is correct, it is business as usual. If it's wrong, then all hell may break loose for advisors who had placed their bets on its prognosis. Prudent advisors will be proactive-basing any course of action on the economy and client risk tolerance levels and weaving risk management techniques into portfolios.
Advisors should especially watch out for a few things. For one, are there any signs of a new downturn in the housing market? If new housing starts declined two to three months in a row, it would be a code red. So would back-to-back months of further initial job loss claims. Either of these two indicators by themselves would be cause enough for concern about a double dip. Together, they could be catastrophic.
Another indicator to watch keenly would be interest rates. We can expect the Fed not to raise interest rates at this point, since such an action could be contractionary and thwart growth. However, we also know that interest rates should start rising to reflect the economic turnaround and the ensuing increase in money demand, mainly by business. If business's demands for money do not increase and money rates remain at or near their abysmally low current levels, then that too would be cause for alarm. Finally, the consumer confidence index would need to show a turnaround as well, showing the public believed in a better future after a period of government and corporate action. That attitude would lead to increased consumer spending, which in turn would stimulate business production and employment.
Advisors wishing to stay a few steps ahead of the competition should watch those four indicators-new housing starts, unemployment, interest rates and consumer confidence-like hawks. At the first sign of danger, they should have time to carry out value protection strategies. The simplest of all proactive techniques would be to construct only very broadly diversified global portfolios using easily traded securities, such as ETFs. Such a tactic would allow advisors to shift quickly and easily among asset classes for reallocation purposes. Alternatively, advisors may take a small position in equity or debt put options-an insurance-like precaution-so that even if the economic read were incorrect (as it could easily be), not all would be lost. Even a small (1%-2%) option put position would go a very long way toward protecting clients against the most harmful downturns. Investors may also reduce the cost of such hedging/insurance by buying puts that are a little bit out of the money.
It is no wonder that many investors today are shy to speculate and that much of the nation's investable funds are currently being held in cash or cash-like securities. For now, investors will prefer to be safe and less rich rather than sorry and poor. Until the signs are better, it is worthwhile for advisors to structure portfolios that have built-in risk management schemes that anticipate another possible economic collapse.
Somnath Basu is a professor of finance at California Lutheran University and the director of its California Institute of Finance. Dr. Basu also serves as a professor of the Helsinki School of Economics executive MBA program. He's involved with financial planning organizations including the National Endowment for Financial Education, the CFP Board of Standards, the International CFP Board and the Financial Planning Association.