Caution is watchword for investors in 2008

December 30, 2007|By Gail MarksJarvis

Confused?

So are the best and brightest on Wall Street as they try to make sense of a housing recession and credit crunch that many experts failed to anticipate.

The intense ups and downs in the stock market in recent weeks are a symptom of the confusion as the economic threats play out in a script analysts haven't read in the past. It doesn't help that even the Federal Reserve has had to amend its views. Fed Chairman Ben S. Bernanke, who previously estimated the subprime mortgage loss at $50 billion, recently pegged it at $150 billion.

Analysts have been writing 2008 outlook reports with titles like Citigroup's "Sifting through the Chaos."

In essence, what the reports are saying is: The U.S. consumer is buying, but can't keep it up indefinitely as a love affair with debt plays out badly in everything from unaffordable homes to tapped-out credit cards. Financial companies are dealing with billions of dollars in pain from misjudging the housing market, and the price tag connected to their errors keeps rising.

Views vary about the likelihood of a U.S. recession, with many putting the odds in the 35 percent to 50 percent range.

"Even if a recession does not transpire in 2008, it will likely be a year of considerable weakness in housing, credit growth, consumer spending and corporate profits," said Abhijit Chakrabortti, a Morgan Stanley strategist. And, in a recent report, he provides this warning to investors: "It is unusual for recessions not to involve at least a period of severe decline in equity prices."

So the watchword for investors as they go into 2008 is "caution" - caution with stocks and caution with risky corporate bonds, or high-yield bonds and high-yield bond funds.

Perhaps the economy will avoid a recession, but the consensus is to tread carefully. The biggest danger for investors could be getting too bold too quickly.

To add to the confusion, investors are finding that old formulas for handling risk haven't been secure. For example, value funds typically are considered the safest among stock mutual funds during recessions, because they tend to buy stocks that are relatively cheap and pay sizable dividends. Presumably the low prices and high dividend yields insulate investors from sharp downturns. But about a third of the value index is made up of financial companies. And even though financial company stocks fell about 20 percent as a group this year, many analysts do not believe the distress has ended.

Instead of chasing financials, Chakrabortti suggests tobacco, diversified telecommunications companies and utilities.

Although some contrarians have urged investors to start investing in financial companies, many analysts say it's too soon.

"We believe there will be a time to buy the banks, but not now," said Keith Horowitz, Citigroup bank analyst, who recently downgraded his view of banks that included Bank of America, Wachovia and JPMorgan Chase. "We are very early in the credit cycle. ... There is too much uncertainty now in terms of how capital markets and real estate will play out."

Likewise, many analysts say investors have underestimated the impact of banking troubles on other businesses.

"As delinquencies and defaults soar, lenders and investors are tightening credit for commercial, credit card and auto lending, as well as for mortgage borrowers," said Morgan Stanley economist Richard Berner.

With loans tougher to obtain, and costs of borrowing higher, he expects some companies to cut back on major purchases.

"Slower top-line growth, sagging operating rates and a downturn in corporate profits all seem likely to promote a 1.7 percent contraction in real business capital outlays over the four quarters of 2008," he said. "Managers will tend to extrapolate a slowdown in business activity into dimmer expectation of future growth, lower perceived returns from investing and reduced need to invest."

Investors, however, have not begun to digest such a slowdown, experts said. Goldman Sachs is warning investors that they should expect to see analysts reduce their expectations for profits. Typically when that happens, stocks fall too.

"The defining event of early 2008 will be the massive cuts to earning estimates" that will occur as analysts discover they were overly optimistic about sales and profits they are expecting for companies, Goldman's portfolio strategies team said in a recent report. "Investors must brace themselves for a sustained wave of significant earnings-per-share estimate reductions during the first half of 2008."

gmarksjarvis@tribune.com

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