Market Forecast of 2008 - What's your view? (part 1)

I read this interesting Market Forecast of 2008 by Bernie Schaeffer.

Just want to share with friends here too...

Year In Review

Imagine the impossible happened around this time last year. You're minding your own business with a nice cup of green tea and you're presented with a truly functional crystal ball (or the souped-up time-traveling De Lorean from Back to the Future). You suddenly have the ability to look one year into the future - a dream come true for an investor (or gambler). With your newfound clairvoyance, perhaps you'd decide to keep those Apple shares in your portfolio or invest in a little thing called Baidu.com. Maybe you'd laugh at the notion of the Boston Red Sox capturing a second World-Series crown in four years. You'd be incredulous at the notion that Kevin Federline would be ruled a better parent than his estranged wife Britney Spears. And then one little prophecy would be absolutely flabbergasting.

The crystal ball (or your "future self") would warn of a hiccup called "subprime," a problem that grew out of short-sightedness and flourished in an environment riddled with rising interest rates and falling home prices. Foreclosures hit record numbers, major mortgage lenders crumbled, and homebuilders hit the skids. The crisis had a self-perpetuating effect - gun-shy banks and lending institutions were hesitant to offer credit, making the landscape that much more challenging for home sellers and builders.

This meltdown in the mortgage market trickled down into global credit markets, as liquidity evaporated. Hedge funds that were largely invested in subprime equities collapsed, banks and brokerage firms wrote off billions of dollars in bad debt, and the merger-and-acquisition deals that dominated headlines in the early part of 2007 became few and far between. Earnings were stunted for financial and homebuilding names, leading to aggregate results that fell short of already-lowered expectations late in the year. And on top of that, crude oil made a charge at the $100 a barrel.

So a clairvoyant investor at the end of 2006 would foresee a shrinking credit market and sparse relief from the housing market's infirmity or crude oil's climb. But if the crystal ball broke before he went back to the future to check out the stock market in 2007, hopefully he didn't spill his tea and rush to protect his portfolio against the worst bear market of the past 15 years. Because - and this is where the other shoe drops - despite all of this madness that transpired but 11-plus months in, the major market averages are sitting near breakeven or even slightly higher for the year. In fact, the Dow (DJIA) overtook two millennium marks (13,000 and 14,000) for the first time, the S&P 500 (SPX) hit a new all-time high, and the Nasdaq Composite (COMP) surged to a new six-year peak. And these gains occurred after the subprime crisis began to reveal itself. Someone looking a year into the future would never believe it. But then, going back to the Red Sox and Kevin Federline, 2007 has been a year of outrageous events.

When you look at all we've stomached, it's frankly quite impressive that stocks have weathered the storm. In light of the fundamental struggles that have plagued the market environment of late, long-term technical support and a sentiment backdrop of caution and skepticism have kept cataclysmic selling at bay. The three separate rate cuts from the Federal Reserve (amounting to a combined drop of one percentage point) have also certainly helped, but they arrived a little late (more on this later).

Currently, we're facing the monetary equivalent of a double-edged sword. Bad news on the economic front is clearly undesirable, in that we never want to see symptoms of an economic slowdown. But if the news is bad enough, the collective conclusion is that the Fed's hand will be forced, spurring another rate cut, and a return to a low-rate environment can signal good news for the market's recovery and the eventual upturn in the housing and credit markets.

As we shift gears into 2008 - a Presidential election year - we look to the Fed for answers. They are the one major wild card here, and a policy misstep from the central bank could cause an unraveling of the technical support that has been so pivotal for keeping the market on an even keel.

Fundamentals

Ben There, Done What?

In the past few months, there has been plenty of hemming and hawing among the most powerful men and women in finance, as Fed officials worry that continued rate cuts could steer the market into an inflationary spiral. I simply cannot emphasize enough how imperative I think it is to this market that an aggressive rate-cutting campaign continue into 2008. I remain floored by the articles I read listing every indication why the bottom will fall out amid the subprime-crises mess, and how many of these pieces fail to even hint that a rate-cutting campaign from the Fed could help ameliorate this problem.

Of course, the hawkish advocate will argue inflationary pressures and the weak dollar. First of all, the greenback stands to benefit from a more prosperous environment - currency traders are as worried as anyone about an implosion in the U.S. economy. And as I've noted before - in The Option Advisor and on SchaeffersResearch.com - lower rates are already built into the dollar - it is the Fed that is lagging behind market rates. With regard to inflation, it is mind-boggling to me that this is a serious concern in the wake of a deflationary banking crisis, a scenario that has never been followed by accelerated inflation.

The yield on the two-year note is below the 3% mark. Libor rates are reflecting a level of tightness in the market not seen since the early 1990s, when we were plagued with the savings-and-loans crisis. The yield curve for the Fed funds and 10-year note has been inverted for nearly 560 days and counting - but we've yet to see recessionary indications. The point is - we're looking at the risk of deflation here, not inflation. This market and this economy need more rate cuts, and if we don't get them, all bets are off.

Recession Ruminations

The idea that the economy is poised to tap the brakes may appear at odds with the notion that stocks will continue to trend higher. In fact, these seemingly diametrically opposed concepts have a historical precedent of going hand in hand. Data reported in a December 10 Bloomberg article reveals that in the past 60 years, the S&P has moved higher in eight of the 10 years that the economy has grown by 1% or less.

But here's the rub … six of those eight increases coincided with periods during which the Federal Reserve was dedicated to a rate-cutting campaign. Since the 1950s, the Fed has cut rates at least three times consecutively on 12 different occasions. In 11 of these instances, higher stock prices followed; the S&P posted an average annual gain of 19.2%. What's more, in the six years when these rate cuts coincided with economic growth of 1% or less, the average gain in the S&P was 23%. Are you listening, Ben?

Earnings Expectations Expose Ennui

When it came to earnings, the trend toward the end of 2007 was increased caution, which came in the form of reduced estimates. By December, the average estimate for fourth-quarter earnings (the lion's share of which will be reported in January) was less than 1.7%. For 2007 as a whole, total earnings are on pace to grow 3.2%, the worst collective earnings growth rate since 2002. This is down from the 9.3% earnings growth projected at the beginning of the year.

This backdrop shows me two things.

First, it's another testament to the underlying strength of the market, which was able to hold steady despite such a disappointing turn in the earnings department. Additionally, from a sentiment standpoint, these low expectations, which are likely to trickle into early 2008 outlooks, sets up the potential for upside surprises to blaze a trail through the market early next year. When analysts and investors are expecting the worst, the slightest bit of good news can spark buying interest. Also remember that the overall earnings picture has been clouded by weakness in finance and housing. Take these problematical pockets out of the equation, and earnings remain on solid ground - perhaps on shockingly solid ground as evidenced by recent very strong earnings reports from major technology stocks.

For the S&P 500 Index overall, I expect earnings growth of around 7% in 2007. My assumption is that consumer spending will not suffer a major hit next year, as Fed rate cuts (again, the wild card here) and other steps to ameliorate the housing slump will shore things up. I'm also expecting to see oil prices moderate and income growth remain strong.

While the financial sector will face continued earnings challenges as the impact of the credit-market woes trickle down, this weakness will be offset by strong earnings growth in such sectors as utilities and technology. I'd expect the weak dollar to act as an overall economic stimulant in addition to boosting the overseas earnings of multinational companies and encouraging foreign buying of U.S. assets. If the Fed cooperates, fourth-quarter 2008 earnings growth could rebound strongly across all sectors, causing a real surge in buying demand.

Lame Duck = Good Luck?

For the first time since 2000, one thing is certain in the upcoming year's political landscape … by the end of the year, a new person will have been elected Commander in Chief (I'd say by the end of Election Day, but we've seen how that can go). No matter the turnout - Democrat, Republican, man, woman, Hollywood actor, or dark horse - the White House will have a new resident come January 2009. What does the changing tide mean for the stock market? Potentially a lot.

But before we get to our 44th President, let's see what we can expect from the final months of George W. Bush, from a market perspective. Historically speaking (back to 1952), the fourth year of the Presidential cycle has been the second best for the market (the best being the third year, although this cyclical pattern didn't live up to expectations in 2007). On average, the fourth year in the Presidential cycle has seen an average annual return of 7.35% in the broad market. The best year by far was 1996. As Bill Clinton easily nabbed a second term against Bob Dole, the market charged 26.01% higher. The worst two years were 1960, when the market fell 9.35% and a controversial election resulted in John F. Kennedy defeating then-Vice President Richard Nixon, and 2000, when the market gave back 6.18% amid the technology bubble-bust.

It's also interesting to note the potentially bullish impact of bipartisan rule. In the past, a discord between Congress and the President has been good for the stock market (possibly because warring factions lead to inaction by government). Noted economist Ed Yardini once observed: "I wholeheartedly encourage people to vote for gridlock; it's good for Wall Street and for Main Street too."

Currently, there's a stalemate, with the White House controlled by Republicans while Democrats hold Congress. Next November, with 35 Senate seats and the Presidential slot up for grabs, we could wind up with a change in both branches. This will be something to keep in mind as we make our financial decisions for 2009.

Crude Awakening

In the fourth quarter of last year, the price of crude per barrel was lower relative the first quarter of 2006. This was certainly not the case this year, as black gold muscled continuously higher for most of the year and briefly threatened to overtake the psychologically significant $100 level.

At press time, long-term crude futures were nearly 43% higher for the year and the average price at the pumps (for regular-grade unleaded) was still hovering around $3.00. The simple fact of the matter is, since crude toppled the $30-per-barrel level in May 2003, black gold has been on an indefatigable run higher. People lamented $50-a-barrel oil and $80-a-barrel oil. And though the rising price of fuel has ultimately impacted everyone, from the commuter fueling up every week to the airline traveler feeling the brunt of higher ticket prices (to the consumer, who has seen the cost of many products increase to compensate for rising fuel), the overall jump in crude futures has been somewhat of a non-issue for the stock market.

Though oil has tripled in value in the past four-plus years, economic growth has remained healthy. The annual gross domestic product (GDP) rose an average of 5.95% from 2003 through 2006 and is currently expected to rise approximately 4.8% in 2007. Unlike the oil crisis in the mid-1970s, when supply was crimped, prices spiked, and filling stations were forced to deal with lines of frustrated customers, today's gains in oil are the product of increased demand. If we were to see oil suddenly fall back even as low as the $50-per-barrel mark, it would probably be the result of some deeper-seeded economic issues. Consumers and the economy have put up with rising oil this long; fuel costs should continue to be digested rather effortlessly in 2008 as well. However, forecasts for GDP growth in 2008 are just above 1.5%. Thus, a slowdown is factored into the market.

Finally, from a contrarian perspective I note that those forecasting crude oil prices for 2008 have adopted a "fool me 10 times, shame on me" attitude, vowing that they will not again be fooled into predicting (as they have, year after year) that the price of oil will revert to the mean and retreat. One of Mr. Market's favorite tricks is to blow away those who modify a long-held stance because they feel they've finally "learned their lesson".

Stay tune for more from part 2 that will further analyze the technical trend and market sentiment...