Worst-case scenario survival guide

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(Money Magazine) -- So is this just a really, really bad year? Or the end of capitalism as we know it? These days it's all too easy to imagine almost anything happening to the economy. And to you.

You've probably already run the movie in your mind about the day you get the ax. Maybe you've even wondered if there's a point at which you'd just mail your house keys to the bank.

And then there's your portfolio. The words "great" and "depression" seem to be popping up together a lot more often. Is there something you should be doing? Like selling your stocks and burying cash and gold bars in the backyard?

Time to get a grip - not by ignoring the worst possibilities but by facing them head-on. Here, then, are answers to six ridiculously scary (but certainly not ridiculous) questions posed by today's economy.

First, let's explain our terms. Economists broadly define a depression as a 10% drop in output and consumption. In the Great Depression our gross domestic product fell 25%. There are some frightening parallels between then and now: Banks are weak, and the economy is loaded up with debt. (See the graphic on the right.)

But historian Eric Rauchway of the University of California at Davis points to big differences too. Strange as it sounds, our financial system is vastly better regulated than it was then. Bank deposits are insured, and the Federal Reserve has taken an active role in trying to stem the crisis. Policymakers have in fact been trying to do everything their predecessors didn't - they're spending like mad, saving banks and loosening up money. (No guarantee that this will work, but it beats doing what clearly didn't work before.) Meanwhile, a social safety net adds stability to the economy that wasn't there in 1930.

That doesn't mean we're in the clear. Market crashes can increase the likelihood of a depression, says Harvard economist Robert Barro. Recently he and colleague Jose Ursua examined crashes and depressions in 34 countries. Based on that record, Barro puts the odds that the U.S. will slip into a depression at one in three, and the chances of another Great one at 6%.

Before you get out that shovel, remember that fear of a deep recession or depression has already pushed stocks down. Could they drop even further as the economy deteriorates? You bet. The stock market fell 25% in 1930 - and collapsed another 43% in 1931.

Then again, investors who bought stocks at the start of 1933 - with eight years of the Depression to go - earned an average of 9.4% a year over the next decade. It's hard to predict when the market will rebound, and it may happen well before the economic recovery is obvious. Try to time the turn, and you could miss a good chunk of the comeback gains.

But what if you just want all the risk out of your life now? You can switch to cash and high-quality bonds. Yields on Treasuries are low, but if consumer prices start to fall, as they did in the '30s, the real value of that income will be higher.

How much do you have to save to meet your retirement goals with bonds? Lots. Say you are a 45-year-old earning $100,000 with $250,000 stashed away. According to T. Rowe Price simulations, you'd need to save more than 40% of your annual income. If you can handle more risk than just bonds, Lou Stanasolovich of Legend Financial Advisers also recommends equity funds that can bet short - that is, make investments that rise in value when stocks fall.

You've probably heard some scary talk about inflation lately. Sometimes the double-digit inflation of the 1970s is invoked; occasionally it's visions of Weimar Germany and people pushing wheelbarrows full of bills. The case for some future inflation isn't paranoid, but here again, it's tricky to position your investments for doomsday. For one thing, you'll have to decide which apocalypse to bet on.

If we actually get a depression (or a recession that comes close), the immediate to mid-range problem is likely to be deflation, which may be far worse than some inflation. Falling prices and falling wages can put the economy into what economic forecaster Gary Shilling calls a "self-defeating spiral." Consumers become reluctant to buy something today that will be cheaper tomorrow, and debts (like home mortgages) become tougher to pay off, further depressing demand. And some classic investments used to hedge against inflation - such as commodities - could lose you money during a depression/deflation cycle.

People warning of a return to '70s inflation or worse are often hawking gold investments. Gold is relatively easy to buy now (no vaults required), because you can use exchange-traded funds like SPDR Gold Trust. Except for run-ups during brief periods of high inflation or financial panic, however, gold has delivered lousy returns - on an inflation-adjusted basis, it's still trading far below its 1980 peak. "Gold is a purely speculative play, which offers no income and no guarantees," says Marilyn Capelli Dimitroff, a financial adviser in Bloomfield Hills, Mich.

All that said, for long-term investors inflation is a legitimate concern. Washington's spending and the Fed's easy money have Tom Atteberry, co-manager of FPA New Income fund, predicting that inflation will heat up in three to five years.

A diversified fund that invests in commodity-producing companies, such as T. Rowe Price New Era (PRNEX), could give you a hedge against rising prices without the extreme volatility of gold.

Treasury Inflation-Protected Securities, or TIPS, are an even easier call. Their principal is adjusted to keep pace with consumer prices, and they're cheap now because the market is still worried more about deflation. Unlike gold, the only way TIPS won't keep pace with inflation is if the U.S. defaults - and if that happens, you may be better off buying canned food and armor-plated doors.

For all too many Americans this isn't even a question - they simply can't come up with their payment this month. But others face a complex tradeoff. Perhaps you can squeak out the monthly payment but have to turn down a better job in another town because your mortgage is too far underwater for you to sell your home. Maybe you're so far away from ever breaking even on the house (see the chart at top right) that you just can't stand to keep throwing money at it. "Some people will find walking makes sense," says Dean Baker of the Center for Economic and Policy Research.

We'll leave the ethical implications of not paying a debt up to you. Here are the purely economic costs you'll have to weigh. First, there's your credit score. If you have a good score, it most likely will drop more than 100 points, according to credit scorer FICO, and the mark stays on your report for seven years. You'll be hard-pressed to buy again anytime soon.

And you should remember that potential employers and landlords may see your credit record, although some of the stigma of losing a house may be wearing off now that we're Foreclosure Nation. Compared with foreclosure, a short sale - where the lender lets you sell the house for less than you owe - might make it a bit easier to get a future mortgage. But it is likely to do just as much damage to your numerical credit score, according to FICO.

Then there are taxes. In the past, if a lender forgave a mortgage, you typically had to pay tax on that amount. A new law offers relief from most of those federal taxes. But it's only for a primary residence, and if you borrowed against the house for anything besides home improvement, you'll still owe tax on that part, says Mark Luscombe of tax publisher CCH.

Also, depending on your state's law and your type of mortgage, your lender may be able to go after you for the money. It is uncommon, but as the crisis grinds on, banks may get tougher. Consult an attorney and tax professional before making a decision.

And check the rental market in your area. You may not save as much as you'd think, especially after figuring in taxes and the burden of poor credit.

You need backup cash like never before. It's taking people longer to find work - a middle-aged worker now can expect an average of six months to rebound from a layoff, according to Moody's Economy.com. And if you have a very senior position it could take longer. So ideally you would have a year's worth of expenses saved, says Chicago-area financial planner Donald Duncan.

Whoa. A year? Even if you're halfway there, the recession will (we hope) be over before you can get all that money together. But don't let that paralyze you. You can get further along faster by halting contributions to your 401(k), IRAs, and college savings, and funneling that money into a high-yield savings account. "You can always turn those back on," says Duncan.

You also want to take a hard look at your 401(k) and IRA investment mix. Tapping retirement accounts for living expenses should be your very last resort, but if you have little or no other savings, you should face the possibility that things could come to that if you are laid off.

Before an emergency strikes, figure out what a year's worth of expenses will be. Subtract what you already have saved and what you might get from unemployment, severance, and possibly family. Whatever is left over might have to come from your retirement accounts. Remember, unless you borrow from a working spouse's 401(k), you'll have to pay federal and state taxes and a 10% penalty on anything you take out of a 401(k) or traditional IRA early. (Like we said, last resort.)

Figure out how much you need to protect, and shift it into money markets or bonds. Perhaps the only thing worse than drawing down your retirement fund early is needing to do so and finding out there's no longer enough there.

First, resist the inevitable urge to slack. This is not the time to back off from a big project - if you can embed yourself in that one last critical task, you may be able to stick around longer. (Ask an AIG trader how this works.) When the hook does come, don't resign yourself to taking whatever they give you, and don't sign anything until you've figured out your strategy.

Start by collecting office scuttlebutt. Find out what other employees got in their packages and what your manager's goals for this layoff are. If he's been ordered to reduce headcount rather than hit cost numbers, for example, you may have a better chance of sweetening the deal.

Haggle as much as possible with your boss, not the HR guy whose job is to gently push people out the door. To be blunt, guilt works better on your manager. "The only way to get more is to negotiate with someone who knows you and is willing to go to bat for you," says Lee E. Miller, an employment lawyer and author of "Get More Money on Your Next Job ... in Any Economy."

You will probably have more leverage if you are part of a legally protected group, which includes being over age 40. Be subtle - you aren't threatening a lawsuit, just signaling that you know your rights and you aren't a pushover, says Miller. Start with these five magic words: "I just want what's fair."

You have money stashed in lots of different accounts, so there's a good chance that a company you do business with will end up in the headlines for its financial woes. But you have some key protections.