Crystal balls always cloud over when the economy enters a recession. Among the blind, the one-eyed observer can become a king. Rarely is the change in the trajectory of business and financial market activity more vexing than when a recession occurs at the end of an economic boom- in this case, the longest bull market in history.

Traditional indicators that held the key to the future in the last expansion particularly decline in predictive value. Businesses and consumers often overreact or underreact to changes in the pace of business activity. And investors, always eager to divine the future, engage in fierce competition to detect a recovery and stake out positions before it becomes obvious to one and all. The race to be first seduces many to jump the gun.

For financial advisors trying to manage client expectations and grow their practices in such an environment, the challenge is daunting.

After all, there are three powerful cycles at work-the overall economic cycle, the equity market cycle and the financial services industry cycle-and they march to very different drummers. Within the financial services industry, the financial advisory business has its own microcycle. It should be recalled that it was the 1990-91 recession that performed much of the spadework for the financial planning boom of the 1990s.

Before figuring out what the recession means for advisors this time around, it's necessary to examine the causes of the current slowdown, the likely outcomes and what they portend for the financial markets. Weeks after the National Bureau of Economic Research announced in early December that the recession had begun in March 2001, Ed Hyman of ISI Group, generally considered Wall Street's most respected economist, said that the recession probably was ending. Hyman may have been ahead of other economists, but the consensus is that the recovery will start in either the first or second quarter of 2002 and move into high gear in this year's second half.

The optimism is based on conventional wisdom derived from the experience of past recessions, when a sudden burst of pent-up demand for deferred purchases of goods and services finally snowballs and translates into transactions. This is the logic behind the V-shaped recovery on which many economists are betting. A classic example was the first quarter of 1983, when gross domestic product soared more than 7% as the economy emerged from the 1981-82 recession that produced an unemployment rate of more than 11%.

There are a few serious problems with the optimists' case. The first is that this recession has been milder than almost any since the 1950s, so that less consumption of big-ticket items has been deferred than in prior downturns. Unemployment may continue to rise in 2002, but it's very unlikely that the jobless rate will top the 7.7% level of the early nineties.

Up until September 11, many economists questioned whether we were in a recession at all. There was a severe recession in capital spending following the bursting of the tech bubble, but consumer spending in 2001 was running 2% ahead of the prior year before the terrorist attacks. While September 11 caused consumer spending to grind to a halt later that month, it recovered surprisingly fast in the fourth quarter, as evidenced by the surge in car sales. But the areas most severely hurt by the terrorist attacks, travel and tourism, are likely to remain soft for the foreseeable future.

One bright spot for 2002 is expected to be the technology area, which played a dominant role in both the boom of the late nineties and the current recession. William Wilby, manager of Oppenheimer Global Fund, notes corporations, which slashed their tech budgets so dramatically in the last 18 months, typically buy computers and software on a three-year cycle. The Y2K situation caused the last round of spending to be concentrated in 1999. With much of that equipment rapidly aging and the recent introduction of Intel's Pentium IV and Microsoft's Windows XP, the reasons for corporations to upgrade are increasingly compelling.

Even if the economy recovers in robust fashion, a prospect that many experts are starting to doubt, there are major problems facing the equity markets. The first is corporate profits, which deteriorated surprisingly quickly in 2001 in light of the mild recession. Further clouding the picture is what Wall Street calls the lack of earnings visibility. Corporate executives are increasingly reluctant to provide earnings guidance, partly because of Regulation FD requiring disclosure to all shareholders large and small and also because economic uncertainty has eroded their confidence in their own predictions.

Exacerbating the problem is the shrinking credibility attached to Wall Street research, to which most institutional investors pay increasingly less attention. Wilby says his firm now takes company earnings reports and reclassifies many items that corporate managements refer to as operating earnings to come up with more realistic numbers.

If that weren't enough, there's the unavoidable problem of the equity market's valuation level. Investors have little faith in the believability of corporate earnings (witness Enron, Lucent and Waste Management) or Wall Street projections of future earnings, but they know valuations still are high, even after a two-year bear market.

What really has many academics and other market experts concerned is the vanishing equity-risk premium, typically defined as the difference between the expected return on equities and the return on riskless securities like short-term Treasury bills. It was the subject of a cover story by Harold Evensky in the April 2001 issue of Financial Advisor and, more recently, a meeting of leading academics and institutional money managers that TIAA-CREF sponsored in December.

A leading bear at this gloomy meeting was Rob Arnott, principal of First Quadrant Advisors in Los Angeles. "The key question isn't whether there will be good news, but whether there will be as much good news as the market is expecting," Arnott says.

Arnott is skeptical about the latter. Both he and Clifford Asness, managing principal of AQR Capital Management in New York and another participant at the meeting, expect real returns of little or zilch for the next five years. "The impact of September 11 is significant, but it's being brushed off by the capital markets," Arnott says. "The expanded role of government adds materially to the scale of government on a long-term basis."

Most bears don't argue that the underlying health of the U.S. economy is remarkably strong. So far, the recession has been benign, and there is no crisis in banking, real estate or energy. But as the bears like Arnott, Asness and Financial Advisor contributors Evensky and J. Michael Martin will tell you, the crisis this time is the stock market's valuation level. They don't necessarily see a huge decline as imminent, but they don't see how a new bull market is sustainable in the next five years.

As Asness observes, the bulls make their case based largely on the magnitude of the market decline since March 2000. But the fact that equities have fallen so far and still remain very pricey may simply indicate how far out of control the bubble got.

Wall Street's expectations may still reside in Fantasyland, but there are signs investors on Main Street are returning to reality. A recent poll by Opinion Research revealed the public expects single-digit returns from stocks in 2002.

It's doubtful, however, that Main Street investors have mentally processed the implications of subpar returns. Take this illustration: In early October 2001, when stocks were cheaper, Financial Advisor interviewed Arnott, who was "short-term bullish" and predicted equities might return 5% or 6% over the next five years. Since then, most indexes have climbed almost 20%. That's the equivalent of about four years of 5% returns. "The [Standard & Poor's 500 Index] has never bottomed at 25 times earnings before," Wilby says.

Arnott and Evensky concede equities could finish 2002 higher than they began the year. But as they see it, the large-cap growth stocks that dominate the market will find it hard to get out of their own way. If a company like Microsoft had such great prospects, it wouldn't be sitting on $36 billion in cash; it'd be investing it. "There's a 1.4% yield on the Standard & Poor's 500 Index, and dividends have historically grown 1% faster than inflation," Arnott says. "Let's say stocks can produce 2.4% more than inflation, which is 2% or 3%. That's a 5% return at a time when bonds are yielding 6%."

Markets possess a proclivity to move in macro cycles, and these observers expect a new cycle is under way. The case for flat-line returns recently was articulated by Warren Buffett. He noted in a speech that between 1965 and 1982, equities fell 50% in real terms, as inflation ravaged financial assets, despite fairly strong economic growth. This was followed by a 17-year period when stocks appreciated tenfold. Even though economic growth was modest until the late 1990s, inflation was eviscerated in every sector of the economy but one-financial assets.

The explosion in financial asset prices inevitably spawned excesses, which rippled through the rest of the economy. But the forces that laid the foundation for the bubble-globalization, technology and the productivity boom-were as real and powerful as the dotcom-based economy was fictitious.

Of all the major economic indicators, productivity is the most perplexing and controversial. Small revisions of gross domestic product translate into huge swings in productivity. But economists generally agree on one thing: Productivity holds the key to variables like wage growth, inflation and corporate profits, major determinants of equity prices. After rising at a slow 1% annual pace in the 1970s and 1980s, productivity accelerated to a 2.4% clip in the mid-1990s, convincing even Fed Chairman Alan Greenspan there was a degree of substance to the so-called New Economy.

On this front, there is some positive news that the bears may be ignoring. The Wall Street Journal reported that a recent study by Harvard University economist Dale Jorgenson and New York Federal Reserve Bank economist Kevin Stiroh looked at productivity in this recession and previous recessions and found that the first recession of this century is different. In eight previous recessions, they reported that productivity fell sharply to 0.14% on average. So far in the first two quarters of the current recession, worker productivity fell marginally to 1.8%, despite the slowdown in capital spending. Jorgenson and Stiroh conclude that U.S. productivity over the next decade is likely to expand at a 2.2% rate, impressive for a mature economy. If they are right, it would permit employers to raise wages at a fast rate and simultaneously drop more to the bottom line.

Just as Wall Street's bulls may be excessive in their prediction of a V-shaped recovery, the bears in academia and institutional asset management probably overstate their case. The likelihood of 17-year flat-line equity market just doesn't square with an economy as dynamic and fast-changing as today's global, high-tech environment. And the return on the S&P 500 has been virtually zero for the last three years, so we're further into this bear market than some think.

Arnott acknowledges that most of his bearishness is directed at large-cap growth stocks. How does one justify companies like Procter & Gamble selling at 38 times earnings that are growing 7% a year? "Large-cap growth is dominated by trendy companies where the fundamental underpinnings aren't as sound," he maintains. "Value is the place to be for the next several years. And small-cap multiples are realistic, and their growth rates are often higher."

Establishing new market leadership is likely to take years and reflect the changing demographics of an aging population in the West. That's why a global investor like Oppenheimer's Wilby is heavily weighted in health-care and financial companies and is avoiding some traditional U.S. consumer stocks. "We own beer stocks in Brazil and Mexico, with younger populations, but not in the U.S.," he says.

Economic expansions are growing longer; there have been only two mild recessions in the past 22 years. Many excesses build up in a 10-year boom, and wringing them out of the system takes time. The recovery of the early 1990s rose at a snail's pace, and between 1992 and 1994 the S&P 500 produced modest single-digit returns ranging from 7.7% in 1992 to 1.1% in 1994. This recovery may be faster than the last, but equity returns are likely to be similar. The next bull market won't get rolling for several more years, not several decades.

A Recession's Silver Lining

When the last recession was at its zenith 11 years ago, many bigwigs in the financial services industry were privately writing obituaries for the fledgling independent advisory business. They couldn't have been more wrong.

Recessions typically witness major shifts in the balance of power in many businesses, providing opportunities for upstarts to take market share from established players. The independent-advisor business transitioned from a fragmented cottage industry into an emerging profession and, in the process, became the fastest growing segment of retail financial services.

Some industry commentators have noted that many financial advisors participated in the planning boom of the 1990s. But it also should be realized that many of today's established practitioners were struggling a decade ago. For some, 2001 was their best year ever.

Richard Wagner, principal of WorthLiving in Denver, recalls speaking to a regional chapter of the Institute of Certified Financial Planners in the early 1990s when he served as that organization's president and asking how many of them "were six months away from bankruptcy at one time." Nobody raised a hand, but he felt an eerie silence reverberate through the room as people started to look around. "Six months is actually a long time to avoid bankruptcy, but it struck a chord," he remembers.

Ron Roge, an advisor in Bohemia, N.Y., increased his assets under management from $4 million to $170 million in the last decade. "Tough times force people on the borderline trying to do it themselves to give up," he says.

Here are several tips from top advisors to make the recession work to your advantage:

Attitudes toward job security can reveal much about clients. Roge has developed several niches, including one among Wall Street traders, who tend to be quite conservative with their own money. "They think they are going to get fired any minute. Though it rarely happens, we work on building a secure foundation, doing things like using bonuses to pay down mortgages," he says.

In contrast, many corporate executives have a false sense of security. "We ask clients, 'How safe is your job?' When they say, 'I'll be there to turn the lights out,' it sends shivers down my spine," says Eleanore Szymanski, principal of EKS Associates in Princeton, N.J. "Their assessment of their own company is almost always unrealistic. The familiarity makes them too comfortable and complacent."

Recessions create excellent opportunities for advisors to persuade clients of the value of staying with the financial planning process and the importance of diversification, which can be a challenge in a roaring bull market. "Clients don't argue against diversification," Szymanski says,

Portfolio performance is unlikely to cover up mistakes clients make when it comes to saving and spending, as it did in the late 1990s. Judy Shine of Shine Investment Advisory Services in Englewood, Colo., is putting a lot more emphasis on cash flow budgeting issues in her meetings with clients these days. "We'll build good muscles here in a period of lower returns," she says. At the same time, she's not emphasizing performance reporting to the extent she used to do. "For many advisory firms, the report is the product, and that's a big mistake," she says.

Communication is critical in hard times. Often it helps the advisor gain confidence as much as it helps the client relax. Norm Boone of Boone Financial Advisors in San Francisco entered the profession in 1987 and quickly started to write. "Writing newsletters to clients helped me a lot. It gave me a reference library in my mind. It helps you collect your thoughts and boost your confidence," he argues.

To search for common threads in practice turnarounds, Financial Advisor asked Anthony Greene, CEO of Raymond James Financial Services in Atlanta and a 30-year veteran of the business, what characteristics were shared by advisors who struggled in 1990 and are prospering today. He didn't have to think long. "One thing that is very clear to me is that people who were wise to convert to a primarily fee business, not necessarily a fee-only business, have done very well," he says. "Most of them got their start in financial planning, and they didn't forget it. Today, asset management is the bulk of their business, but they still put a lot into financial planning."

A recession is the best time to convince clients to buy into the financial planning process. "Making sure new clients stay with it is the hard part, but knowing that their cash needs are met is very important to their comfort level," Szymanski says. "Clients can get very smug when they see their friends nervous. We are often buying when their gold partners are selling. Our clients know that this, too, shall pass."