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Where to Invest in 2008

Profit handsomely from what's happening half a world away.

By Andrew Tanzer, Senior Associate Editor

From Kiplinger's Personal Finance magazine, January 2008

To paraphrase Dickens, think of 2007 as a tale of two economies. The home-building bust, crumbling housing prices and mounting credit woes sapped the domestic economy. As a result, stocks tied to housing and the U.S. economy sagged. But such businesses as natural-resource producers and capital-goods exporters, which are tethered to the robust global economy, had more bounce in their step, and shares of those companies sizzled.

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In 2008, we expect a similarly bifurcated stock market. The U.S. economy and consumer will be subdued, but investors will have plenty of opportunities thrown up by the boom in emerging markets. As bombs continue to explode in the portfolios of U.S. banks, international sales of American goods and services will surge. The fortunes of various industries will diverge widely.

With more uncertainty than usual about the health of the U.S. economy in general and the banking system in particular, expect plenty of big ups and downs from stocks in the year ahead. One plus for stocks is that they are relatively cheap. As a result of the market's flop this past fall, Standard & Poor's 500-stock index traded in mid November at 14 times estimated 2008 earnings. That's a bit below the market's average long-term price-earnings ratio and cheap compared with current interest-rate levels.

The rub is that the market may not be as cheap as it looks. Analysts expect S&P 500 earnings to jump 14% in 2008, says Thomson Financial. But if the economy flirts with recession and if financial companies continue to take massive write-offs on mortgage investments gone sour, growth of that magnitude is a pipe dream.

We think U.S. economic growth will be anemic -- less than 2% -- in the first half of 2008, but it stands a good chance of staying positive. The Federal Reserve's interest-rate cuts in the summer and fall of 2007 will stimulate the economy. Employment has held up (so far) and incomes are growing. Millions of Americans are drowning in too much mortgage and consumer debt, but enough of them are spending to make a recession unlikely (consumer spending accounts for 70% of the total U.S. economy).

Add it all up, and the S&P 500 should return between 5% and 10% over the coming year (on the lower end of the range if profits are soft, on the higher end if they are anywhere near analysts' forecasts). Look for stocks to struggle early in the year in response to negative news about the economy and earnings and to pick up in the second half as investors start anticipating better times in '09.

The overseas factor

Powerful demand from abroad has been puffing up profits of multinational U.S. companies -- from Boeing, Caterpillar and Schlumberger on the industrial side, to Coca-Cola, Colgate-Palmolive and McDonald's on the consumer end. S&P calculates that overseas revenues for the companies in the S&P 500 have jumped from 32% in 2001 to 48% in 2007 (see the chart below). Joseph Quinlan, chief market strategist for Bank of America Capital Management, thinks that as much as 80% of the earnings growth of U.S. companies came from abroad in 2007. "Foreign profit growth was the dominant factor boosting the S&P 500 in 2007," agrees Bank of America economist Lynn Reaser. We fully expect the trend of rising exports to continue in 2008. (For more on the role of exports, see Exports Steer the Economy.)

You can view the economic crosscurrents this way: The housing collapse has been subtracting about one percentage point of gross-domestic-product growth each quarter from the $14-trillion U.S. economy. Net export growth has been generating a point or more of GDP growth, offsetting the ailing domestic economy. Score one point for the potent force of globalization, often denounced at home and abroad.

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