Your stocks: Riding out a recession

E-mail Money Magazine editor-at-large Michael Sivy at msivy@moneymail.com.

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NEW YORK (Money) -- The Federal Reserve's large interest rate cut on Tuesday is just the latest sign that experts think the economy is heading straight for recession.

In fact, the conventional wisdom is that the U.S. economy entered a recession in December.

It's worth remembering, however, that a literal recession - two back-to-back quarters of economic decline - isn't inevitable. And the actual evidence that one has begun is quite limited. We won't really have crucial data until preliminary fourth-quarter GDP numbers are reported later this month.

Nonetheless, it's likely that the U.S. economy will be weak for most of the year.

So the natural question is: How much further do stocks have to fall? Are the potential losses so big that investors should be making lots of changes to their portfolios?

It's certainly sensible to be somewhat defensive, whether there's a full-scale recession or simply a slowdown.

Diversification is less important in a bull market when a rising tide lifts nearly all boats. But when stocks are falling, some groups really get pummeled while others hold up surprisingly well. So spreading your risk is especially important.

Assuming that you have always been well-diversified, there's a good case for staying the course and not selling a lot of stocks or massively reshuffling your holdings. If anything, you should be tracking stocks that you might want to buy later this year at bargain prices.

Here's the basic case for just hunkering down to ride out the current slowdown:

Most recessions are fairly short Of the 10 recessions since World War II, only two lasted more than a year. Those two - in the mid-1970s and the early '80s - were crushing and did merit substantial portfolio readjustments. But more often, recessions only disrupt investment strategies temporarily.

The stock market isn't the economy Growth may be way below average all this year, and unemployment may continue to rise. But the stock market anticipates future trends, and share prices typically start to recover six months or so before the economy rebounds. That means share prices could be rallying by mid-year.

Valuation matters more than growth Really big losses occur when stocks are hugely overvalued, as they were in the late 1990s. The recession that followed lasted only eight months, but share prices fell for more than two years. Last year, however, stocks were only modestly overvalued. And share prices could probably get through a mild recession without falling a whole lot more than they already have.

The worst news should be out soon It may seem as though banks and financial services companies just keep reporting bigger and bigger losses. But after audited fourth-quarter results are announced - which should happen over the next six weeks - most of the really bad news should be out. After that, there will actually be the possibility of positive surprises, if banks have written off too many loans and some prove to be recoverable.

The economy is increasingly global Companies get 30 percent of their profits from outside the U.S. That's up from 20 percent only a decade ago. And some multinationals earn more than half their money abroad, especially in the technology sector. So a big chunk of the stock market will have some support if U.S. consumer spending dips.

It rarely pays to fight the Fed The one stock-market indicator that really works is Federal Reserve policy. Typically, the Fed doesn't slash interest rates until a recession is well under way. But when there's a banking crisis like the present one, the Fed cuts interest rates early and often. That's happening now and should fuel a robust recovery starting within the next 12 months.

Of course, there's the possibility that something worse is going to happen, and defensive investing is always smart in bad times. But your one big advantage as an individual investor with long-term financial goals is that you don't have to worry about quarterly performance.

Rather than struggling for a profit in the next three months, your goal should be to maximize your average return over decades. You don't do that by dumping stocks when the market is down or by trying to bail out and then jump back in at a lower price. You do it by staying fully invested and looking for opportunities to add bargains to your portfolio.

So limit your risk by diversifying as broadly as you can and perhaps trimming a few stocks that look overpriced. But otherwise stick to your investing plan. If you have cash beyond what you regularly put away, consider adding some multinationals to your holdings, especially if they're trading at price/earnings ratios that are less than 20 times earnings for the past four quarters. Beyond that, all you can do is wait for the market to rebound - as it eventually will.