The Wall Street Journal-20080113-Where Market Surprises Lurk in 2008
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Where Market Surprises Lurk in 2008
The stock and bond markets moved higher during a rocky 2007. But things are off to a tough start so far in 2008, amid growing indications of an economic downturn.
The Dow Jones Industrial Average is down 5% so far this year and the Nasdaq Composite Index is down 8%, after losses last week of 1.5% and 2.6%, respectively.
Most strategists predict the stock market will have problems in the first half of the year, as housing troubles and slowing consumer spending weigh on corporate profits. Things could improve later in 2008, thanks to expected interest-rate cuts by the Federal Reserve. Most experts anticipate a strong year for foreign stocks, as growth abroad powers ahead.
A year ago, when we speculated on developments that could take the market by surprise in 2007, our story accurately anticipated deep troubles in the subprime mortgage business and robust foreign growth, though it incorrectly anticipated a spate of energy acquisitions and higher price-earnings ratios.
What might catch investors by surprise this year? Below are some unorthodox predictions:
The dollar has slumped in recent years, in part because U.S. growth has been meek compared with foreign economies, especially those of emerging-market nations. Most investors expect the trend to continue, as the U.S. tries to skirt a recession.
But the greenback could be stronger by year's end. While expectations of a U.S. slowdown are widespread and some investors have already sold dollars, most haven't worried enough about the impact abroad, argues Richard Berner, a Morgan Stanley economist.
If U.S. consumer spending weakens, it will impact foreign economies, especially big exporters, putting pressure on their currencies. Pressure also will build on foreign central banks to cut rates to stimulate their economies, which could also push foreign currencies lower. And if the U.S. can put the credit crunch behind it later this year, or the downturn is not as bad as feared, the dollar could recover nicely.
The implication: Go easy on foreign stock and bond investments.
Oil prices recently touched $100 a barrel and remain above $90, amid rising global demand and supply pressures. But as the U.S. economy slows, it will impact global growth, crimping energy demand. At the same time, there's growing investment in alternative energy sources, which could boost supply.
Over the long term, oil should stay strong, because it is becoming harder to tap new major energy sources. But in 2008, the direction of crude could be lower.
Duncan Richardson, chief equity investment officer at mutual-fund company Eaton Vance even predicts "oil back under $70 [a] barrel," amid "a global economic slowdown."
Global economic weakness also could push all kinds of commodities, from copper to grains, lower, especially if China slows. That would put pressure on a range of U.S. commodity producers and emerging- market stocks. At the same time, the Chinese stock market could tumble "as pressures grow to rein in inflation, pollution [and] misallocation of resources," says Citigroup strategist Tobias Levkovich.
On the bright side, commodity weakness could make U.S. consumer spending stronger than most expect.
The subprime mortgage crisis could spread in 2008 to areas like credit cards and auto loans. If more consumers are unable to pay their debt bills, that will cause more losses for financial companies and potentially weigh on broad markets.
There are growing indications of problems. On Thursday, American Express warned that slower consumer spending and more credit-card delinquencies will hurt profit this year. Capital One Financial set aside $650 million to prepare for unpaid credit-card bills.
The problems could spread from consumers to companies in 2008, as capital spending slips and debt defaults, which have been running at very low levels, jump. That likely will hurt some junk bonds.
There's also anxiety about the growing credit-default-swap market, where insurance against debt defaults is bought and sold. The cost to buy insurance to protect against default on debt issued by big financial companies is rising, signaling rising worries about some big banks and insurers.
Banks and bond insurers have written billions of dollars of the credit protection traded in this market. If defaults materialize, they will be on the hook. Some say losses on these instruments could amount to $250 billion or more.
"We remain concerned that the amount of losses generated due to writing of insurance on mortgage-backed securities in the form of credit default swaps is relatively unknown, which could test the solvency of a major bank," says Charles Gradante, managing principal of Hennessee Group, a hedge-fund investment firm.
Technology shares have been the worst performers lately, amid the slowdown fears and because the troubled financial sector represents as much as 18% of U.S. and global tech spending.
But some stocks now look cheap, argues James Paulsen, chief investment officer at Wells Capital Management.
If global growth resumes apace, tech shares should lead the market higher. Semiconductor stocks now trade at close to five-year lows, based on trailing sales and projected earnings.
Multinational companies like Microsoft (MSFT), Oracle (ORCL) and Cisco Systems (CSCO) are favorites of cautious tech investors.
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