This is very difficult to forecast, as we are at an inflection point in our economy.  A much more difficult forecast than it was back in the fall, when I pulled roughly 70-80% of my money out of the stock market.  Maybe, I’m the only one that thinks that, but to me it was blatantly obvious at the time.  This time it’s not so obvious.

On the one side we have the declining housing market, inflation, battered financials and tight credit, and on the other side we have ok corporate earnings and strong exports from multi-national companies.  In the middle sits unemployment.

The unemployment rate has inched up over the past few months, and in 6 states it has gone over 6%.  Two of those states, Michigan (7.2%) and California (6.2%), are huge parts of the U.S. economy, and any problems they have will likely hurt the rest of the U.S.  California itself is the 5^th largest economy in the world, so this is not an easy negative for the U.S. economy to overcome.

While our largest city, New York, is just starting to feel the pinch from the recent financial mess, and some believe Wall Street layoffs could hit 20% of the financial professionals in the city.  This is trickling down to foreclosures in the Hamptons.

All of this news sounds bad, but the overall unemployment rate is hanging around 5%.  Historically, that’s not a terrible number.  The problem is that unemployment lags a recession, so by the time the numbers show up the damage has already been done.  This means we would have missed any opportunities to sell before a decline or buy before a run-up in stock prices.

How can we comfortably predict where the economy/market is headed?  Well…we can’t.  You can never be 100% certain.  Though, I was about 99% certain last fall.  However, this doesn’t mean you should just bury your head in the sand and dollar cost average index funds until you lose 20% of your net worth (a future article will deal with dollar cost averaging and index funds…not a big fan).

When I look at inflation*, which the government says is at 4%, but is really much closer to 7-8% the potential of the domestic economy seems muted.  How can people with steadily declining purchasing power continue to pay mortgages they couldn’t afford in the first place?  They can’t, which means a downward spiral begins.

Maybe our economy can be saved by positive company earnings propping up employment. Unfortunately, it appears we might be on the last leg of positive earnings.  Companies can’t make money if they can’t sell products, and right now, the banks/financial companies are so gun shy, and so undercapitalized, they won’t loan money.  GE Financial is refusing to loan ANYONE any money to buy motorhomes or boats.  Admittedly, motorhomes and boats aren’t enormous industries, but they are the canary in the coal mine.  These types of industries get hit first in a downturn, as they are huge expenses with little need.  No credit = no earnings.

Another good measure of the economy is kind of related to Peter Lynch’s advice, “Invest in what you know.”  In this instance it should be, “Pay attention to what you know.”  Pay attention to friends, neighbors, family members work and financial situation.  I don’t mean ask around, but just noticing that Bob doesn’t go to work anymore or that the Henderson ’s house has been up for sale for 8 months, suggests there are problems in the economy.

A good example is my situation.  My company just let 7-8% of its workforce go, which doesn’t bode well for the future.  Along with these layoffs real estate in my area ( Washington , DC ) seems to be a little hyped.  Everyone keeps saying real estate hasn’t been hit hard in this area, but yet on my drive to my gym, there are 3 townhouses within a 2 block walk from a subway in one of the nicest neighborhoods in the metro area.  These townhouses have been for sale for at least 6 months.  Either there aren’t any buyers or the prices are too high, either way it’s not good.

My best guess suggests it’s going to get worse before it gets better, so I don’t plan on putting a lot of money back into the U.S. market in the near future.  If I do it will be select stocks that have some factor mitigating the potential economic downturn.

Make sure those emergency funds are fully stocked, start cutting expenses, and have a plan already laid out in case the worst happens.  If your investment strategy is pure buy and hold, then don’t panic and pull your money out when the market takes another hit.  If you move in out of stocks and funds, then revaluate your current holdings with an eye to a potential downturn.

…above all think for yourself.

*  The government uses a flawed formula to calculate inflation.