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Where the markets are headed in 2008

Choosing the right investments in the coming year will not be easy. Many Wall Street pros are advocating defensive strategies, and a few, surprisingly, think 2008 might turn out to be a pretty good year for the markets after all.
/ Source: Business Week

Choosing investments for 2008 is like trying to find a decent Christmas tree in a nearly empty lot. Stocks? Not with earnings expected to fall. Bonds? The safe ones are overpriced. Real estate? You gotta be kidding. With a credit crunch in full bloom, housing still on the skids, and a recession threatening, this is a singularly bad time to be hunting for assets that you can brag about owning a year hence. "It's going to be different magnitudes of weak," says David A. Rosenberg, chief North American economist at Merrill Lynch.

Still, all hope is not lost. In this Special Report on Where to Invest, we'll tell you what some of the most successful investors are forecasting for the year ahead. Many are advocating defensive strategies that focus on preserving wealth in trying times. A few, surprisingly, think 2008 might turn out to be a pretty good year for the markets after all. What's indisputable, though, is that the current situation is unlike anything we've seen since at least the early 1990s. Puzzling out a strategy for dealing with it requires some hard thinking, so let's begin.

The most important influence on the 2008 investment outlook will be the continuing turmoil from the bursting of the credit bubble. The problems began in the housing market, where prices had been pumped up by super-easy financing terms such as no-documentation loans and subprime mortgages with below-market teaser rates. The pain spread to the financial sector, which had underestimated the risk of profligate lending. Even outside the U.S., people who put dollars in banks are so nervous about the banks' safety that they're demanding 1.8 percentage points above the rate that they could earn on three-month Treasury bills, vs. a premium of just 0.4 percentage points last spring.

Unsold houses
For investors, the chief risk is that the credit crunch will claim more victims in 2008. Nearly 3% of housing units that are intended for homeowners rather than renters are vacant, which is the most since record-keeping began in 1956. Many economists think the glut of unsold homes will cause a further 5% or 10% decline in prices in the coming year or so. As prices fall, the ranks of homeowners who owe more on their mortgages than their homes are worth will swell. "You've got a $23 trillion asset class [housing] that is in a deflation mode," says Quincy Krosby, chief investment strategist at Hartford Financial Services Group.

Even though job growth has remained respectable, the price decline in real estate to date has caused an outbreak of bankruptcies, foreclosures, and multibillion-dollar writedowns. It stands to reason that further price drops will bite far more deeply, especially if they're coupled with job losses.

There is a growing risk that 2008 will see the first consumer-led recession since 1990-91. Interest rates have steadily declined since the early 1980s, but consumers, rather than using the lower rates as a chance to get out of debt, have taken on more and more. According to the Federal Reserve, households' financial obligations were 19.3% of their disposable income in the third quarter, which was a hair below the 2006 record but well above the 1980 level of around 15%. That may be unsustainable. Defaults on auto loans have begun to rise, and troubles in credit cards could be next.

How to play this treacherous situation? Unless you have a strong tolerance for risk, it makes sense to go conservative by investing in companies that have strong balance sheets and are relatively insulated from the woes of the American consumer. Health care, for example, rolls along in good times and bad. Tech companies tend to make a lot of their money from stronger overseas markets. In fixed income, steer clear of structured products that may or may not be exposed to toxic subprime debt. Buy ultra-safe Treasuries or take just a smidgen of risk on municipal bonds, whose yields are more attractive for taxable accounts.

And invest globally. Advisers have been saying for years that most Americans are overexposed to the ups and downs of the U.S. market because they keep almost all of their money at home. That mistake looms larger now that the dollar is sliding, the U.S. economy is soft, and global growth is robust. This is the time to bone up on foreign securities and reallocate that 401(k). Also: Stash money in Treasury inflation-protected securities in case inflation accelerates.

Challenging times favor investors who focus on companies with abundant free cash flow. Such companies can survive even if debt markets shut down and no one wants to buy their equity. Seek stocks whose prices are justified by solid, ongoing businesses rather than market speculation about riches to come. William W. Priest, CEO of New York's Epoch Investment Partners, says stockpickers have to understand companies' competitive positions, not just how they stack up by accounting metrics. More than ever, "a business analyst is worth a lot more than a financial analyst," says Priest.

Financial leverage has gone from being the key to wealth to a big fat mistake. When lending was still lush, investors accepted thin premiums for buying the securities of riskier firms. They rationalized that they could sell out whenever they needed to. What's clear now is that "liquidity that looks great on Monday can be gone on Wednesday," says Marc D. Stern, chief investment officer of Bessemer Trust in New York. Stern considers the current retrenchment "a healthy correction to a period of a great deal of excess." His picks include health-care stocks, tech firms that have a big share of their sales abroad, and Asian markets such as Singapore, South Korea, Malaysia, and Japan that do business with booming China and India but have lower P-E's than those of the twin giants.

Still, there's a bullish case to be made for U.S. stocks in 2008, if the economy manages to dodge a recession. For one, strong growth abroad could help prop up earnings. 3M, for example, forecast on Dec. 12 that its earnings per share in 2008 would rise by 10%, thanks in part to emerging markets.

Meanwhile, the Federal Reserve will probably cut rates further if the U.S. economy continues to weaken, which could give stocks a shot in the arm.

There could be more fiscal stimulus, too, if the White House tries to amp up growth ahead of the 2008 Presidential election. Here's a bit of trivia: According to Stock Trader's Almanac 2008, the Standard & Poor's 500-stock index has risen in the final seven months of every election year since 1950 except one.

And optimists dispute the notion that U.S. consumers are bound to quit in 2008. "When Americans are happy, they spend money. When they are depressed, they spend even more money, as long as they aren't losing their jobs," writes economist Edward Yardeni, the president of Yardeni Research.

For some stock market bulls, the best news for the market is investor pessimism. The p-e ratio for the S&P 500 based on trailing 12-month earnings is just over 18, vs. well over 25 in 1999 and 2000. That means that on average, investors are paying moderate prices for companies generating respectable profits. The UBS Index of Investor Optimism plunged 26 points in November, to 44, which was the lowest since right after Hurricane Katrina. Once everyone has capitulated, the contrarians figure, there's no one left to bail out, and stocks have nowhere to go but up.

If you buy the bullish case, you might consider buying beaten-down banking stocks, which offer attractive dividend yields at current prices. The trick is figuring out which banks have already come clean on their loan losses and which ones haven't.

Still, no one knows how much farther the housing market will fall, and this factor will determine how much damage the financial sector and the economy are going to have to absorb. Under these conditions, betting on the stock market is a high-risk proposition. It's hard to get too excited about the 2008 outlook when the most positive thing you can say about the year is that (to quote the contrarians) everyone has given up on it.