This is a great question that more and more candidates seem to be asking of late, especially in this market. First and foremost, I think it is very important to be as honest and forthright with your recruiter as possible from the very beginning about all aspects of your job search, including the reasons why you are looking for a new position. Transitioning to a new job can be a very stressful experience, and recruiters want to make this process as easy as possible for you. In addition, recruiters work very hard on behalf of their candidates in order to help them find that perfect, new job. However, in order to allow your recruiter to do the best job possible on your behalf, it is imperative that you provide your recruiter with all important and relevant information regarding your background, experience and job search. Withholding potentially negative information from your recruiter will only cause problems down the road because this information seems to inevitably come out at some point, and usually to the detriment of the candidate. It is much better if your recruiter knows all relevant facts from the outset of your job search so that she can determine the best possible way to handle your specific situation.
With respect to your specific case, I do believe that honesty is the best policy as the truth always seems to come out. Firms routinely ask lateral candidates why they are leaving their firm, and the fact that you are being laid off because your practice group is slow is unfortunately becoming more and more commonplace. Thus, it is nothing to be ashamed of, as firms seem to be a bit more understanding of your situation. However, it is very important that you are able to provide strong references from your current firm in order to alleviate any concerns that you are being laid off for performance-related reasons.
In addition, by not disclosing your current situation upfront, you may find yourself in the awkward position of no longer being employed in the middle of the interview process with a potential employer. At this point, it will be very difficult to explain the change in your employment status because the firm will recognize that you have been withholding important information from them. This can be very detrimental to the interview process, and ultimately lead to disastrous results.
For example, a few years ago, a former candidate of mine was in this exact situation - ie, he had been laid off from his firm, and the firm had told him to not tell his recruiter the truth about his situation because it would hurt his chances of finding a new job. Thus, he never told me that he was being laid off and only had a few months to find a new position. This candidate had no problems getting interviews as he had outstanding academic credentials and was at a top Los Angeles law firm. Thus, he successfully obtained several interviews, and ultimately received an offer to join a fantastic firm. However, unbeknownst to me, this candidate was no longer employed at his firm when the offer was extended. In fact, the candidate had misrepresented his employment status when he had gone on his last interview with the firm. Obviously this was not a good situation. At the end of the day, both I and the firm finally learned the truth about this candidate's situation. When the firm found out, they rescinded the candidate's offer because of the misrepresentation, and not the fact that the candidate had been laid off. Because of the candidate's numerous misrepresentations and lack of disclosure, the firm had serious concerns about the candidate's ethics and integrity. Had the candidate told me and the firm the truth about his situation from the beginning, the firm would not have rescinded the offer. In addition, I had lost complete faith in this candidate and was no longer able to trust that what he was telling me was the truth. As a result, I stopped representing this candidate.
In summary, while your situation is an unfortunate one, it is not an insurmountable one. Unfortunately in this economy, lay offs are becoming more common. However, there are definitely opportunities out there for candidates like yourself. To be able to capitalize on these opportunities, trust your recruiter to be able to handle your situation in the best appropriate matter. Best of luck!