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The first day of trading for 2008 was the worst “opener” since 1983. Despite this, I am quite optimistic for earnings, the economy and stock prices. In the first half of 2007 there was scarcely a mention of sub-prime mortgages, CDO’s, SIVs and the TED spread. I suspect when the markets close on 2008, movements will have been dominated by news decidedly different from the aforementioned.

Of course for now, we must contend with the fact that markets are being driven by the twin fears of inflation (oil topped $100 and gold closed at an all time high last week) and recession. Despite the plethora of bad news to start the New Year there are reasons to be optimistic.

Recent economic data has not been all bad. Manufacturer’s orders rose last month, non-residential construction spending continues to climb and light vehicle sales persist in their ascent. Despite a drop in the median price of a home last month, more single family homes sold than in the prior month and inventories of unsold homes declined modestly.

There are also reasons to be optimistic that the worst of the credit crisis may be behind us as the asset backed commercial paper [ABCP] market increased in size by $26 billion last week indicating lenders are less averse than in recent months. This was the first up week since August 8, 2007. The LIBOR minus Fed Funds spread dropped to 40 bps last week indicating that fear is draining from the credit markets. (Credit the Fed’s Term Auction Facility or TAF). The equally important TED spread (Three month treasury minus three month Eurodollar) declined to 139 basis points from the 220 bps pre TAF. This number is still elevated from the 20-60 bps range pre-August suggesting we are not completely out of the woods yet.

January will be a test for sure and will likely set the tone for 2008 as $473 billion of ABCP will mature representing 58% of the total market. In addition investors will pay close attention to the Citigroup (C) earnings call on January 15th. During their November 5th conference call, Citi’s management said regarding fourth quarter write downs:

We expect it to be between $8 billion to $11 billion on a revenue basis and $5 billion to $7 billion on an after tax basis.

Any visibility on finality of the write offs should be greeted warmly by investors.

The Economy

I expect Q4 GDP and Q4 earnings to be soft driven by the housing and credit mess. Companies are expected to take write offs in Q4 in hopes of setting themselves up for favorable YOY comparison opportunities in 2008. While Q3 2007 saw heavy financial asset write offs, Q4 will include the same plus write offs associated with restructuring, divestitures, and impairment of goodwill. As 2008 progresses and financial strains ease, the financial asset write downs of Q3 & Q4 2007 could easily become gains in the latter half of 2008.

As we meander through 2008 I expect the housing drag to diminish. After all, residential construction spending has declined for two years and housing starts are now 45% below their peak. The consumer effect of rising home prices on GDP is estimated to have been roughly .5% of GDP and I expect only a .3% to .4% drag effect from the current price declines.

I expect the energy drag to diminish on the economy as well. Slowing growth in demand and increased supplies should provide relief. Energy is still just a commodity and we can count on rational profit seeking entrepreneurs to deliver additional supply along with new alternatives and increases in efficiency.

The Federal Reserve should continue to provide liquidity and the effects of the Fed’s first rate cut will begin manifesting themselves in the economic numbers. We expect the Fed governors will finally “get together” on the demand risk vs. inflation risk debate and cut rates enough to stimulate the economy.

Despite the challenges of today, investors would be wise to use their foresight and invest in anticipation of the recovery.

Source: Invest in Anticipation of Recovery