The Economy: Five Signposts to Recovery

Things are gloomy?and getting gloomier. How will investors know when it's safe to come out again? Here's what to watch for

by Ben Steverman

Nearly all economists think the U.S. economy is skating on some very thin ice, and some believe we've already plunged into recession.

The economic data paint a scary picture. A weak holiday season for retailers. An uptick in unemployment. A decline in manufacturing. Still more pain for the housing and financial sectors. Both business executives and average consumers are wary of spending.

Investors responded predictably to the recession worries, sending major stock indexes tumbling. Half a month into the year, the Standard & Poor's 500-stock index has dropped almost 6%.

Things may look bleak, but eventually conditions will improve. The key question for investors looking for buying opportunities is when that happens. For example, will the economy grind on in low gear for much of the year, or will it bounce back strongly by the summer?

We asked economists what early signs of a recovery might be.

For now, most of these indicators are getting worse, not better. But if the economy decides to break out of its funk, these trends should give you a heads-up.

1. Will Washington take action, and will it work?

It's an election year, and "neither the White House nor Congress want to be seen as doing nothing," says Avery Shenfeld, economist at CIBC World Markets (CM). That's why some are betting Washington will step in with some fiscal stimulus, doling out extra cash to get parts of the economy moving again.

To be a successful policy, "you need to get money into people's pockets now," says John Silvia, chief economist at Wachovia (WB). "Now" is the important part, and may be the most difficult to accomplish. Republicans would rather spur business investment by, say, cutting capital-gains taxes, but Democrats are talking about measures aimed at a broader swath of the public, like a Social Security tax rebate.

The 2008 election may actually make compromise more difficult. Real fiscal stimulus might have to wait until after the election?by which time it will be too late, says Joe Liro of Stone & McCarthy Research Associates.

Rather, Liro says, that other arm of the government?the independent Federal Reserve?is "pretty much the only game in town." Low interest rates, pushed down by the Fed, help ease one of the big headwinds on the economy: "the credit squeeze," the reluctance of financial institutions to lend money amid credit market uncertainty.

The Fed already started cutting interest rates last fall, which is good because lower rates can take as long as a year to have a real effect on the economy, economists say. Thus, look for signs in the spring that looser credit is helping the economy.

2. Oil and the consumer

On Jan. 15, Citigroup (C) said delinquencies on its loans to U.S. consumers were increasing rapidly, and not just on residential mortgages, a problem for months, but credit cards, auto loans, and personal loans. On the same day, a report showed retail sales falling 0.4% in December.

They were yet more evidence the U.S. consumer is having trouble making ends meet.

Kurt Karl, chief U.S. economist at Swiss Re (RUKN.DE), believes consumers are getting squeezed by high energy and food prices. After paying for the necessities, he says, "they don't have much left over." If energy prices fell, "that would allow the consumer to spend a little bit more on other things."

Oil hit $100 recently, but it's now trading closer to $90 per barrel. A weak economy in the U.S. and prospects for a slower European economy raise hopes that oil could fall even lower, Karl says.

3. Jobs

Economists differ on the importance of measures of the job market, such as the unemployment rate, which hit 5% in December. On the one hand, it's a key measure of economic pain, showing whether businesses are confident enough to hire and determining how much consumers have to spend. But it is a lagging indicator. The economy can look like it's still adding jobs three to six months into a recession, Karl says.

However, "employment still holds the key," says Peter Cardillo, an economist at Avalon Partners. If the unemployment rate keeps rising, it will cause many more months of sluggish consumer spending, he says. If job numbers don't get much worse, or stabilize, it could be a sign that the slowdown will be quick and relatively painless.

4. Housing

It's clear that the troubled housing sector pushed hard on the economy's brakes in 2007. The housing market's troubles hurt economic growth and employment figures, while also punishing the financial institutions that issued mortgages in the past few years.

So will 2007's villain become 2008's savior? Not likely, economists say. Many still think housing prices could drop another 10% or more.

Things look so bad that "people will need to be convinced that it's a good idea to get back into housing," says Michele Gambera, chief economist at Ibbotson Associates, part of Morningstar (MORN). That could be a tough sales job, with home prices still at unaffordable levels, a "big inventory" of unsold homes sitting on the market, and the prospect that foreclosures could add thousands more to the market this year, Gambera says.

Still, some economists are looking for good news in this dark and dreary corner of the economy. We don't need a rebound in the housing sector, Silvia says, but he is looking for some sign of stability, perhaps an indication that home buyers' attitudes are starting to shift. That could be a sign that a major weight is lifting off the economy's back.

5. Global growth

For the U.S. economy, the one bright spot is exports. Many U.S. corporations report strong growth overseas, where many economies are booming and the weak U.S. dollar makes American products more competitive.

It's crucial to a U.S. recovery that this trend stay in place. "The global economy is slowing," Cardillo says, "but not falling off the cliff or heading for recession." Liro suspects the Western European economy may slow down, but demand from Latin America and Asia should keep growing, giving the U.S. a much-needed boost.

Changes in government policy, oil prices, the job market, housing, or the global economy each could help save the U.S. from recession. But each factor could also get worse.

The economy may avoid recession, but economists still warn that even positive growth can be painful if it's slow. It may not be an official recession, but unemployment can rise and the economy can limp along for quarter after quarter. Whatever happens, "it's just not going to feel very good," Liro says.

Meanwhile, investors will wait patiently for the first crocuses of spring to poke their heads through the dreary winter snow.

Steverman is a reporter for BusinessWeek's Investing channel.