A weakening dollar and record oil prices. No end to the housing slump in sight. Additional writedowns due to the subprime mortgage crisis. Concerns over higher inflation and slowing economic growth. The growing probability of a recession in the U.S. Sound familiar? These are all issues that plagued markets during 2007, and while a new year will bring new resolutions for traders, it appears they will continue to wrestle with these same problems in 2008. The major averages did finish 2007 in positive territory, but extreme volatility caused dramatic shifts during the later months, and indices finished well off their highs for the year. The Dow Jones Industrial Average added 6.4% during the past 12 months, but was 6.3% off its all-time high set in October. Similarly, the S&P 500 ended 6.2% off its record high, and the Nasdaq Composite was 7.2% below its 2007 top. "Stock market volatility, which had been noticeably absent the last several years, made its unwelcome return in 2007, and in a big way," says Steven Sheldon of SMS Capital Management. "Unfortunately, I do not see the volatility letting up much in 2008 with the economy transitioning into a lower gear." Robert Pavlik, chief investment officer with Oaktree Asset Management, predicts that headwinds will continue to swirl after companies report their fourth-quarter earnings and provide their forecasts. "Due to the cloudy nature of the economy and hesitancy of banks to lend, I expect earnings guidance to be more cautious, leading to a challenging first half of the year for the U.S. equity markets," says Pavlik. Indeed, earnings are expected to kick off the year on the wrong foot when Alcoa ( AA) reports on Jan. 9. According to Thomson Financial, fourth-quarter earnings for S&P 500 companies should decline by 8.7%. That contrasts with a positive growth rate of 10.6% in the fourth quarter of 2006, coincidentally the last quarter of double-digit earnings growth. Still, however ominous the year begins, earnings should get healthier as 2008 rolls on. Thomson expects that profits for the first quarter, which will start trickling in around April, should show a 5.8% growth rate. In fact, it should get better with each succeeding quarter. While Thomson anticipates that earnings grew a meager 1.4% during the 2007 calendar year, expectations are for profits to rise 15.6% during 2008.
"The estimates are certainly coming down for 2008, but they're still higher than this past calendar year," said John Butters, research analyst with Thomson. "Since 2007 estimates have been dropping faster, the growth rate for 2008 is actually increasing." While earnings growth may improve, investors will still have to contend with a slowing U.S. economy, as growth will likely disappoint for at least a few months. In statements that followed its last three meetings of 2007, the Federal Reserve went as far as to say economic expansion will continue to slow over the near term. At those meetings, the central bank lowered the fed funds rate by a combined 100 basis points to 4.25% in order to promote economic growth. With the next two-day Federal Open Market Committee meeting scheduled for the end of January, most expect the central bank to continue cautioning Wall Street about the risks of higher inflation and slowing growth. Hopes are that further rate reductions in the new year will couple with cuts in 2007 to help stabilize U.S. equity markets. Pavlik says he would like to see further reductions in the fed funds rate of at least 25 basis points at each of the policy meetings scheduled for January, March and April. His forecast is for the rate to hit 3.50% by year-end. "Additional rate cuts are needed to continue the flow of capital through the financial system and to promote growth, as well as confidence to individual consumers and businesses alike," he says. "However, with core inflation back over the target high of 2%, I am less optimistic this will occur." One bright spot for the U.S. economy in 2007 was the strength of U.S. exports, thanks to a perpetually weakening dollar. Sheldon says that the soft greenback, the strong global economy and a slower pace of imports have worked to reduce the trade deficit in 2008. "Over time, this should help halt the dollar's slide and reduce inflation, as the stronger dollar will make imports more affordable," Sheldon says. "Strong exports are also cushioning the economy from bearing the full brunt of the housing downturn. If the U.S. economy is to avoid a recession, continued strength in exports will be crucial." Paul Mendelsohn, chief investment strategist with Windham Financial, says that a bulk of the economic recovery effort will have to do with what the government's nonfarm payrolls reports say about job growth over the first half of 2008. "If we begin to lose jobs, it would certainly make things worse," says Mendelsohn. "If we fall into a recession, it will continually feed upon itself."
Of course, stronger-than-expected job growth could also roil equity markets, as the belief is that the Fed will not lower rates because of fears of inflation creeping higher. The question then is how important Fed rate cuts will be to the recovery of financial and housing stocks that have been crushed under the weight of the subprime crisis. "Down the road, some of these securities may turn out to have more value than what Wall Street thinks they do," said Mendelsohn. "If foreclosures can slow down and if banks can find a way to renegotiate some of the paper, there may be some resolution." Most analysts are in agreement that financials will take the first step toward resolving their exposure to subprime-related losses by taking massive -- and in some cases larger-than-needed -- writedowns during the next quarter or two. That might give the financial stocks that were battered in 2007, such as Citigroup ( C), Countrywide Financial ( CFC), Bear Sterns ( BSC) and Merrill Lynch ( MER), the ability to erase their subprime liabilities and start fresh in 2008. Pavlik is optimistic about a quicker resolution to the credit mess, saying that "as mid-year approaches I expect the banks and brokers will have largely reduced their risk exposure to subprime investments. "As the subprime risk is reduced, banks and brokers will resume normal lending practices," adds Pavlik. "Whether they can back to normal lending remains to be seen," argues Mendelsohn. "It depends on how much liquidity the Fed can put out there. The Fed also doesn't want to feed an inflationary problem. Tighter standards are now falling into place, and banks are realizing past mistakes in lending. We won't go back to where we were, but it'll be somewhere in between." As for what should have the potential to gain ground over the near term, look to what had a solid second half of 2007 -- namely technology, energy and mining. "Looking out to 2008, or at least the first quarter or two, we are not seeing a shift in the leadership, technical indicators or any fundamentals to suggest that the broader trading ranges will be broken," says Marc Pado, U.S. market strategist with Cantor Fitzgerald. "Technology has worked well in the fourth quarter, so I would expect that in the first quarter," said Mendelsohn. "Energy has also remained strong. It looks like
crude oil prices are going to $100 a barrel."
Apple ( AAPL) is expected to be one of the early tech winners of 2008, as shares closed out the previous year near all-time highs for the company. Additionally, Apple is expected to unveil new products, including a long-rumored ultrathin flash memory computer, at its MacWorld Conference in January. On the flip side, financials and homebuilders are the two sectors analysts want to avoid, just as they did during the latter half of 2007. "Clearly, financials are oversold, but it's not an area I'd want to be in," said Mendelsohn. "It's for speculators. There's very little in the banking and brokerage areas that are attractive. There's also nothing in the homebuilding area I'd be looking at." The second half of 2008 is harder to predict, as many feel the market's direction hinges on the outcome of the presidential election in November. Should a Democrat take over the White House, there could be some concern with regard to the health care sector's performance. On the other hand, if Republicans maintain control, then defense and aerospace stocks, such as Halliburton ( HAL), Boeing ( BA) and Lockheed-Martin ( LMT), should continue to thrive. One thing that all can agree on is that financials and their potential recovery will be the big story of 2008. "Financial stocks are a big component of the large-cap value category and will be a wild card next year," says Sheldon. "While they may rebound from oversold conditions, I don't see the fundamentals supporting the earnings growth necessary to get a sustainable recovery until late next year at the earliest." If the overall market is to advance in 2008, it might very well need participation of the financials. The question is whether they'll go along.