What happened in mid-May to the economy’s momentum?  What events or series of events derailed the promising economic rebound then underway?  The answer to these two questions is less important than the implication.  The economy no longer appears to have enough “escape momentum” to jump over the economic hurdles in the foreseeable future.  Those hurdles are:  (1) housing remaining in the doldrums, (2) unemployment remaining distressingly high, (3) the wind-down of economic stimulus, (4) spending cuts by state and local jurisdictions.

Looming on the time horizon is the huge income tax increase scheduled to begin January 1, 2011.  Unless something changes, we are going to implement the largest tax increase in US history. And we are going to do it at a time when new economic research suggests that growth may be in the 1% range and unemployment will still be in the 9-10% range. Extended unemployment benefits will be long gone for many people. Housing will still be in the doldrums. Much of what passed for growth was inventory rebuilding and stimulus. The underlying economy may be weaker than the headline number reveals. And by the 4th quarter, there is very little stimulus. 

Let me be clear about something.  In theory, the US economy SHOULD not dip back into recession next year. Double-dip recessions are rare. The last one we had was in 1980-82, and then it was Volker with his foot on the inflation brake that caused it. I certainly think the data tells us it will slow down as the stimulus starts to go away, but a slow “Muddle Through” Economy is not a recession.

Given the above, I think we have to increase the odds of a 2011 recession and those odds will rise and fall based on the economic performance of the next two calendar quarters AND a growing concern in Congress and the White House that the 1/1/2011 income tax increases cannot be permitted to be implemented in their entirety without upsetting the economy. 

But, the stock markets have already dropped in anticipation of the economic slowdown.  There are indications the forecasted downturn is now fully factored into stock prices.  If true, this would not be the time to sell.  On the other hand, the economic downturn could be turn out to be much more long-lasting and severe than the market experts are forecasting.  It is very difficult to predict its severity.  Due to the lack of clarity in my crystal ball, I recommend the following for investors:

1. Investors who do not intend to touch their investments for 5 years or longer – continue to hold the current allocation of investments and continue to monitor.

2. Investors who are withdrawing income from their portfolios for their living expenses – keep 5 years’ worth of income in a short-term bond fund.

3. Investors who anticipate withdrawing lump sums from their portfolios for special purchases e.g., new car or home renovation – “park” any amounts you expect to withdraw within the next 5 years in a short term bond fund.