Introduction December 20, 2007, 5:00PM EST

Where Things Are Headed in 2008

Many see dark days for investors. Let's hope for a rapid resolution of the housing and credit crunch

by Peter Coy

Choosing investments for 2008 is like trying to find a decent Christmas tree in a nearly empty lot. Stocks? Not with earnings expected to fall. Bonds? The safe ones are overpriced. Real estate? You gotta be kidding. With a credit crunch in full bloom, housing still on the skids, and a recession threatening, this is a singularly bad time to be hunting for assets that you can brag about owning a year hence. "It's going to be different magnitudes of weak," says David A. Rosenberg, chief North American economist at Merrill Lynch.

Still, all hope is not lost. In this Special Report on Where to Invest, we'll tell you what some of the most successful investors are forecasting for the year ahead. Many are advocating defensive strategies that focus on preserving wealth in trying times. A few, surprisingly, think 2008 might turn out to be a pretty good year for the markets after all. What's indisputable, though, is that the current situation is unlike anything we've seen since at least the early 1990s. Puzzling out a strategy for dealing with it requires some hard thinking, so let's begin.

The most important influence on the 2008 investment outlook will be the continuing turmoil from the bursting of the credit bubble. The problems began in the housing market, where prices had been pumped up by super-easy financing terms such as no-documentation loans and subprime mortgages with below-market teaser rates. The pain spread to the financial sector, which had underestimated the risk of profligate lending. Even outside the U.S., people who put dollars in banks are so nervous about the banks' safety that they're demanding 1.8 percentage points above the rate that they could earn on three-month Treasury bills, vs. a premium of just 0.4 percentage points last spring.

UNSOLD HOUSES

For investors, the chief risk is that the credit crunch will claim more victims in 2008. Nearly 3% of housing units that are intended for homeowners rather than renters are vacant, which is the most since record-keeping began in 1956. Many economists think the glut of unsold homes will cause a further 5% or 10% decline in prices in the coming year or so. As prices fall, the ranks of homeowners who owe more on their mortgages than their homes are worth will swell. "You've got a $23 trillion asset class [housing] that is in a deflation mode," says Quincy Krosby, chief investment strategist at Hartford Financial Services Group.

Even though job growth has remained respectable, the price decline in real estate to date has caused an outbreak of bankruptcies, foreclosures, and multibillion-dollar writedowns. It stands to reason that further price drops will bite far more deeply, especially if they're coupled with job losses.

There is a growing risk that 2008 will see the first consumer-led recession since 1990-91. Interest rates have steadily declined since the early 1980s, but consumers, rather than using the lower rates as a chance to get out of debt, have taken on more and more. According to the Federal Reserve, households' financial obligations were 19.3% of their disposable income in the third quarter, which was a hair below the 2006 record but well above the 1980 level of around 15%. That may be unsustainable. Defaults on auto loans have begun to rise, and troubles in credit cards could be next.

How to play this treacherous situation? Unless you have a strong tolerance for risk, it makes sense to go conservative by investing in companies that have strong balance sheets and are relatively insulated from the woes of the American consumer. Health care, for example, rolls along in good times and bad. Tech companies tend to make a lot of their money from stronger overseas markets. In fixed income, steer clear of structured products that may or may not be exposed to toxic subprime debt. Buy ultra-safe Treasuries or take just a smidgen of risk on municipal bonds, whose yields are more attractive for taxable accounts.

And invest globally. Advisers have been saying for years that most Americans are overexposed to the ups and downs of the U.S. market because they keep almost all of their money at home.

Reader Discussion

 

BW Mall - Sponsored Links

Buy a link now!