Slow Start, Fast Finish for Markets?

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Investing has always required a thinking cap. But in 2008, investors might be better off with a helmet. A slew of troubles—including falling home prices, logjammed credit markets, disappointing corporate earnings, and surging oil prices—have turned economic prognosticators into party poopers.

While observers debate whether 2008 will include an outright recession or simply a slowdown, one thing remains certain: "This doesn't look like something we'd sign up for just for the fun of it," says Michael Farr of investment manager Farr, Miller & Washington, who predicts subpar returns for stocks in 2008.

In the face of such gathering gloom, it would be easy for investors to write off the whole year even before the first pass is thrown in the Super Bowl. But in reality, there are plenty of reasons for investors to remain optimistic about 2008.

Topping the list is the Federal Reserve. The central bank has already reduced the federal funds target rate by a full percentage point to 4.25 percent, and analysts think it could move to 3.5 percent or lower by midyear. A looser Fed is usually good for stocks and is the primary reason why Sam Stovall, the chief investment strategist at Standard & Poor's, projects the S&P 500 will gain about 12 percent this year and finish around 1650. While the first half of the year may be rough going, the market should pick up in the second half, "because the rate reductions will have started to kick in," Stovall says.

And while sinking home values and rising gas prices are additional head winds, the American consumer has certainly not rolled over yet. Jonathan Golub, the chief investment strategist at Bear Stearns, says labor market stability—the unemployment rate is still just 4.7 percent—will help drive the S&P 500 up about 16 percent, to 1700, by the end of 2008. Consumers' "most important asset is not their house—it's their job," Golub says.

Finally, because 2008 is an election year, the market may have a tail wind. Since 1945, the fourth year of an election cycle has been the second-best-performing period for stocks, with the S&P 500 gaining an average of 8.6 percent a year. (The third year is the best with a typical 18 percent gain, though the market was up just 3.5 percent in 2007.) James Swanson, the chief investment strategist at MFS, says stocks could gain as much as 13 percent next year and admits he's "hitching a little bit" of his view on historical precedent.

Play defense. Investors can position themselves to succeed in a bisected year—where a slower-growing first half picks up steam in the second—by starting from a defensive crouch in large-cap, value stocks from the consumer staples, healthcare, and utilities sectors. Then, should the economy and market accelerate, investors can get more aggressive through small- and mid-cap growth stocks in cyclical sectors, such as technology, financials, consumer discretionary, and industrials.

To be sure, bad news from any number of economic fronts could send stocks tumbling. But high-quality government bonds can help insulate investors from such a downturn. David Ader, the head of government bond strategy at RBS Greenwich Capital, recommends buying two- to five-year treasury bonds—or funds that do—because they offer stability from equity market volatility and should rise in value as the Fed lowers interest rates. Furthermore, the higher rates that banks are paying to attract funding have made certificates of deposit increasingly appealing. "Yields of over 5 percent on these federally guaranteed instruments are pretty remarkable," Ader says.

And despite all the naysaying, 2008 could yet turn out profitable for stock investors, too. But just in case it doesn't, better keep that helmet handy.