In recent months, we've been hearing some strange new terms floating around the financial media, all relating to what "shape" the recovery take the form of. We've heard about the "V-shaped" recovery, where the economy and stock market bounces off the bottom quickly and returns to its former highs.
We've heard some speak of more bizarre shapes like the "square root recovery," the "U-shaped" recovery, and the "L-shaped" recovery, all variants of a scenario in which the old highs are not to be reached for quite some time.

But the most dangerous shape floating around the phrase-o-sphere is the "W," whereby the stock market rises initially (which we've already seen), then dips back down to the bottom again, retracing the old bottom. This shape describes the double dip recession, which would do great damage to investors, policy makers, and the economy at large. (For further reading, check out Survival Tips for a Stormy Market.)

What is a Double Dip Recession?
This can be best explained via the most important gauge of growth and recession, the U.S.Gross Domestic Product (GDP). Most economists define a recession as two consecutive quarters of declining GDP. Our current recession has been longer than most, with a full four quarters of negative growth. But lately, most prognosticators are forecasting GDP growth in the last half of 2009, which would signal an end to the recession.

But what if that growth can't hold, and 2010 brings a renewed downtrend in this most important measure of economic health? Then the double dip recession is in, because the second leg down would be inexorably tied to the first - in essence, it would all be part of the same recession.

Why Could This Happen?
There are those who say that the growth we'll see in the second half of the year is artificial, caused not by genuine improvement but by short-term government stimulus efforts and inventory re-stocking by depleted companies. These folks believe that our extremely high unemployment rate, weak banks, a shaky real estate market and government reform measures will stifle any attempt at recovery - in short, they see more pain to come before the economy can truly heal.

Who can Prevent it?
While no one person or entity should shoulder full responsibility here, Ben Bernanke and the Federal Reserve Board can play a big role in preventing a double dip by keeping interest rates low into 2010 and beyond. One mistake Mr. Bernanke & Co. could make is to start raising rates sharply ,as soon as we see any growth in GDP.

It has been Fed policy in the past to raise rates whenever economic growth begins to turn sharply upward in order to stave off inflation. And we may indeed see big GDP numbers in the third and fourth quarters of this year. But they will be in comparison to dreadful numbers in the same periods last year, so in nominal terms it will be pretty mild growth. The Fed should be able to recognize this, and by their admissions of late they seem intent on keeping rates low for a long time.

Uncle Sam, We Want You Too
The government can also help to prevent a double dip by doing everything in their power to stimulate jobs growth. We know unemployment to be a lagging indicator, which means that the rate can still be high, even though the recession is over. But until the unemployment rate shows a definite downward trend, the danger of a double dip recession is quite real. 70% of our economy is based on consumer spending, and without a healthy (working) U.S. consumer, a full-blown recovery is hard to imagine.

Double Dip Warning Signs
Want to spot the double dip before it comes? Sure you do. Here's how:

  • Look for short-term interest rates rising quickly without surefire signs the economy has fully recovered. This could stifle the pace of recovery by limiting banks and other financial institution's ability to lend money cheaply to both individual consumers and corporate borrowers.
  • Unemployment continues to rise – While this is a lagging indicator, if the unemployment rate stays high for too long, there will too much overhang for the market and economy to get past.
  • Listen to guidance from bellwether companies, such as Coca-Cola, Microsoft, Intel, American Express, Caterpillar and JP Morgan. These firms have operations worldwide and make it their business to keep their ears to the ground. If the economy is fully healed, companies should be raising their guidance into 2010 and beyond, and be speaking confidently about the future.

Parting Thoughts
It doesn't look as if a double dip is in the cards, as the government stimulus is seen as slow-moving, meaning that it's best punch is yet to come. But that doesn't mean we're out of the woods – the double dip is still a threat. Investors should be willing to enter the stock market at this point, but keep flexible, mobile and keep your ears to the ground. The next two quarters will tell us an awful lot about how the next two to three years will be.

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