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We're told that a recession is coming, or at least something that looks, and feels like a recession. In fact, we're told a lot of things. Some of the predictions actually pan out, but most just fade into oblivion. Alas, distinguishing one from the other is always a problem, and at times like this it threatens to be a bigger problem than usual.

The economy, after all, faces a number of risks, starting with ongoing pain inflicted from the housing correction. The collective toll promises to be substantial in the quarters ahead, or so we're told by a fair number of dismal scientists and former government officials.

In the latter category is one Larry Summers, who's receiving a fresh bout of media attention with his prediction that a recession awaits the U.S. economy. As the former Treasury Secretary wrote in Sunday's Financial Times, "the odds now favor a U.S. recession that slows growth significantly on a global basis." He cited a number of reasons, starting with the housing sector, which he feared may be in a "free fall." The proper response, he counseled, may be one of cutting interest rates again, along with some other prescriptions. But even if his recommendations are carried out, he admits that there's no guarantee that a recession will be averted.

Or, we might add, that a recession is coming. Yes, we agree that the warning flags are waving and that only a fool would ignore the economic risks at this moment. We're of a mind to think that the risks are higher than usual, and so a strategic-oriented portfolio should, within reason, be positioned to take advantage of any future volatility. But don't confuse danger signs with absolute clarity about what comes next.

With so many pundits emphasizing risk over return these days, some may be inclined to think that it's now a sure thing that a recession will arrive. But is it really that easy? Is economic forecasting now obvious and transparent?

No, of course not. Forecasting is as messy and difficult as ever, perhaps even more so. That doesn't minimize the risks at hand, but it reminds mere mortals such as your correspondent to keep the future in its proper prospective, in good times as well as bad. Consider, for instance, GDP's quarterly history. As our chart below shows, the trend is rarely obvious at any given point in time.

Note how quarterly GDP growth fell sharply in 2006. By this year's first quarter, GDP's pace was down to a scant 0.6% rise. The future, some argued, looked clear at that point and so the remainder of 2007 would suffer recession. And who could argue? After four years or so of robust GDP growth, it appeared that the cycle was due to change, or so an observer in, say, May, might have reasoned. How could the economy rebound with so much weighing on it? But as the subsequent GDP reports show, rebound it did.

Ah, but now it's due to reverse course, right? Maybe. There's still some debate about whether recession, or just slower growth awaits the economy. That raises the following question: Depending on which future awaits, how should stocks and bonds be priced?

For strategic-minded investors, there's opportunity embedded in the debating. The potential for surprise lives on, which suggests that Mr. Market may overreact one way or another. Perhaps the recession will be deeper and longer than expected. Or, maybe modest growth will survive.

Whatever comes, the market's overreaction may be offset by investor emotions run amuck. Excess confidence, for instance, is always a risk and its presence can be identified by an asset allocation strategy in the extreme. Remember the hefty overweighting in tech stocks circa 1999? The emotional inclination has been known to work in reverse, too, such as the inordinate fondness for cash in the early 1980s.

Opportunity may be coming in one or more of the major asset classes, but no one can be sure. Yes, an overweight in cash looks increasingly savvy. But how much of an overweight is too much? Or too little? No one knows, which is another way of saying that diversification still reigns supreme, for all seasons. And if you're only confident that you don't know, Mr. Market's weights will do quite nicely as a long-term proposition. To the extent that you think Mr. Market's wrong, your allocations will differ. But tread carefully. In the long run, Mr. Market's strategic mix has been tough to beat. Why? It's not because he's so smart, but rather that, investors tend to go to extremes. Investing, in short, is still a loser's game, even if a recession looms.

Source: Is this Recession Forecast Accurate?