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Outlook 2008

Guarded Posture... For Now...


We start the new year with a guarded view of financial markets.  Specifically, we expect the past year's volatility to spill into 2008 and cause financial markets to remain volatile as they adjust further to a weak economy.  The economy continues to struggle against a housing recession that could last for several years; consumer indebtedness that has reached a record 130% of disposable income (was 90% pre-2000); and ongoing credit issues which should continue to manifest itself in a variety of ways for some time to come.  We also think today's profit and growth expectations are too high and are likely to be cut with business' response to falling profits remaining the critical "swing issue" for 2008.  As this all unfolds, we expect risk aversion to remain high and traders to be short-sighted and intolerant of negative surprises.  Until adjustments are made and fundamentals once again begin to show positive momentum, equity markets may find it difficult to sustain rallies.  

2008 could also be a year that refreshes investor appetites and becomes the staging ground for a renewed equity bull market.  We note that most of the recent excesses in investing (i.e. real estate, emerging markets, credit markets, and commodities) have occurred away from the mainstay U.S. equity markets.  The S&P 500 is essentially at the same level it was at the start of the millennium, and large-capitalization stocks have returned little more than 2% above the long-term Treasury bonds over the last twenty years (that same number was close to 6% when Alan Greenspan made his infamous statement about "irrational exuberance" ten years ago).  Now, with the S&P 500 trading closer to its underlying earnings potential, we can begin to envision a bullish case emerging once we navigate through the choppy waters that we see immediately before us.

Stocks & Bonds

The equity markets, measured by the S&P 500, have advanced for each of the past five years.  This stretch of uninterrupted gains was accompanied by a long stretch of rising quarterly profit growth.  This growth ended in the third quarter of 2007.  We also saw an end to growth in non-financial, economy-wide profits in the second quarter of 2007, according to data found in the National Income and Product Accounts.  This also was the quarter that equities began to lag in performance compared to long-term Treasury bonds (see chart).  Despite the data and the markets' reaction, most analysts expect earnings growth to rebound sharply in the second half of 2008 and produce another year of double-digit growth.  We believe that peak profit margins, trough tax rates, rising credit costs and slower domestic volume growth  might make it more difficult for companies to generate earnings growth much above 5-10% for the year, net of dollar translation effects. 

Pulling it all together, we see the potential for a recovery in equity prices following some initial volatility early in the year with a 5-10% rate of return on major market indices from current levels.  Our initial "fair value" estimate for the S&P 500 at year-end 2008 is in the range of 1,550 to 1,625 with a midpoint target of 1,588.  Further drops in the Federal Funds Target Rate are likely, and longer-term yields are likely to be stuck near current levels so long as core inflation on personal consumption remains in the range of 1-2%, excluding food and fuel, and below 3% overall. 

Economy in '08

The economy decelerated in 2007 as the unemployment rate rose to 4.7% from 4.4% in 2006 led by a deceleration in private sector job creation.  Year-over-year, private sector job growth has slowed to a "stall speed" growth rate of 1%.  While employees of the government certainly count in the economy, the hiring trends in the private sector tell us more about the forward view on the economy as businesses expand and contract hiring plans.  We continue to see layoffs in the Financial and Construction industries, which threaten to jeopardize overall private sector job expansion in 2008, and therefore, we expect the unemployment rate to rise to above 5% during the year.  

With further slippage in job creation likely, we envision an economy which starts out with negative-to-slightly positive real growth in the first half of the year accelerating to a low single-digit growth rate later in the year.  We note that slippage in demand in the United States has had the effect of depressing the dollar throughout 2007.  Taken together, the lower demand for imports coupled with currency driven exports, has served as an "automatic stabilizer" for domestic production as calculated by the Bureau of Economic Analysis.  With the dollar already off significantly from its highs and other banks such as the Canadian, Australian, and British central banks have already taken action to lower rates in response to what they see as slowing growth, we expect to see narrowing trade deficits to contribute less to GDP growth next year while trends in consumption and investment remain soft.  

2008 Recommended Tactical Asset Allocation

Our asset allocation has moved from decidedly underweight equities to a more neutral posture.  We continue to emphasize larger-capitalization growth stocks in the United States along with some foreign exposure in growth related sectors and countries with strong international trade and growth profiles.  The income and defensively oriented portion of portfolios currently stress higher-quality credits, laddered Treasuries, and a modest exposure to gold as a hedge against a weak dollar.

2008 Recommended Sector Allocation

Our recommended sector allocation continues to emphasize those sectors that are consistent generators of earnings or exhibit a strong long-run secular growth dynamic.  The sectors are concentrated more heavily in those groups whose earnings are less leveraged to changes in global economic growth rates.


We begin 2008 with a guarded outlook and lingering concerns about credit, real estate, and the consumer.  The largest potential "swing factor" for the year should be business' response to the changing environment.  We continue to monitor the relative performance between stocks and bonds, private sector employment, and profits to identify a potential entry point for signals as to what comes next for the economy.  However, as we navigate these volatile markets, we expect to find opportunities.  We still perceive value in large-capitalization equities and sectors that demonstrate consistent growth in earnings.  Our year-end target for the S&P 500 is 1,588, and our year-end target for long-term Treasury bond yields is 4.5% with a 3.5% Fed Funds Rate.  

Past Commentaries

December 7, 2007

NBER President Raises Recession Concerns


November 28, 2007

Equity Risk Heightened - Allocation Remains Defensive


September 25, 2007

After the Rate Cut


July 30, 2007

The Case For Growth


June 15, 2007

Data Affirms Tactical Asset Allocation Posture


March 19, 2007

Cutting Earnings And Equity Target

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The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved.  Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.  Indices are unmanaged, and you cannot invest directly in an index.

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