Eye on 2008: Investment Strategy for a Challenging Market

Despite the slump in the housing market, widening credit spreads, and high food and energy prices, the major U.S. stock indexes [DJIA (DIA), Nasdaq (QQQQ), and S&P 500 (SPY)] managed to post gains in 2007. With an eye on slowing economy in 2008, investors started favoring large cap growth stocks, which have international exposure and benefiting from the weak U.S. dollar.

Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group Inc. and Nomura Securities International Inc. are all predicting a recession in 2008. Goldman Sachs economists, leading the bear camp, have lowered this year’s U.S. GDP estimates to 0.8% from 1.8%. Many reports have also indicated that consumer spending has slowed and the 2007 holiday season was the worst in years. The benchmark index S&P 500 index has lost nearly 10% as of January 18th, taking the broader market to its lowest in 15 months and below its mid-August low. With the prospect of a U.S. recession increasing, global market sentiment has been souring year-to-date.

Although the overall stock market outlook does not look good, there is still a plenty of ways to make money.. With tremendous volatility in the market, stock picking can be very difficult without careful research. Therefore, I also included a few exchange-traded funds. The following is my 2008 outlook for a few industries that I follow. The major factor that can contribute to the upside/downside risks to the outlook is the economy.

Oil

According to Standard & Poor’s bottom-up estimates, the energy sector would post a mere 5.6% earnings growth this year. Analysts aren't expecting many surprises or significant earnings outperformance from the sector. The broad-based decline of oil stocks have continued amid industry earnings which was kicked off by Schlumberger Ltd. (SLB), one of the largest oilfield service providers. The stock took a beating due to lower-than-expected forecast for international growth and increasing fears that energy demand will soften as the world economy slows down this year. According to the International Energy Agency, oil prices could continue to slide as the U.S. economy cools and demand for petroleum products slackens. A convenient way to long/short a basket of oil stocks in the S&P 500 is through Energy Select Sector SPDR ETF (XLE).

Outlook: Negative

Gold

The top performing industry YTD has been gold stocks, as reflected by the DJ US Gold Mining Index that gained 6.62%. While the long-term outlook for industrial metals such as iron ore, nickel, aluminum, zinc and copper is still favorable due to global infrastructure boom, the global economic slowdown in 2008 can weaken consumption. In contrast, the demand for gold has been trending upward driven by favorable supply-demand fundamentals and investor interest in the bullion's ability to hedge against a weakening U.S. economy and sliding U.S. dollar. John H. Hill of Citi Investment Research has kept his gold price target of $750 in 2008, $800 in 2009 and $820 in 2010, but said the precious metal could "test" the $1,000 mark this year. The basic ways to invest in gold is through ETF streetTRACKS Gold Shares (GLD) and gold equities. My top pick is Barrick Gold (ABX), which is the largest gold producer in the world with an expected 2008 production of 8.3 million ounces. Citi has a 12-month target price of $62 for the stock.

Outlook: Positive

Financials

Financial stocks have been hit badly by the surge in U.S. subprime defaults that began last summer, and many have revealed huge write-downs or sold additional shares to raise capital. Although the sector’s earnings is estimated to grow 24%, be mindful that this is attributed to easier comparison with last year and the sector is set for further downward revisions going forward. As the housing downturn and problems with mortgage-backed securities spills over to the broader economy, it has hurt financial firms from brokerage houses, bond insurers, mortgage lenders, to regional banks. Also worth paying attention is the rising delinquencies on consumer debt. This is a troubling signal for credit-card related companies such as Capital One (COF) and American Express (AXP). I advise investors to be careful on “value-traps” although many stocks are trading at trough multiples and above-average yields. Fed rate cuts maybe trigger short-term rallies in the sector, but I would hold back until the end of 1H 2008 to jump in if the outlook has indeed improved. Citi's (C) 41% dividend cut may be the leading indicator of additional cuts by more financial firms struggling to preserve cash. A simple way to make bets on this sector is through ETFs tracking the sector such as Select Sector SPDR Financial ETF (XLF).

Outlook: Negative

Auto

Given the weak macroeconomic backdrop, I would avoid the auto sector as a whole. General Motors Corp. (GM), Ford Motor Co. (F) and Chrysler LLC have all announced first-quarter production cuts, citing slower demand as consumers continue to be rattled by high fuel prices and trouble in the housing market. Furthermore, U.S. auto suppliers are unlikely to see financial improvements this year amid industrywide overcapacity, pressure on auto makers to cut prices and expectations for lower sales, according to Fitch Ratings. A significant portion of the production cuts will be in the large pickup truck segment, which will particularly hurt suppliers with the most exposure to that part of the market such as American Axle & Manufacturing Holdings Inc. (AXL), Lear Corp. (LEA), and Magna International Inc. (MGA).

Outlook: Negative

Health Care

The health care sector is generally viewed as a safe have for investors during economic downturn because while consumers may reduce discretionary spending, health care is typically a necessary expense. A stock worth watching is large-cap health insurer Humana Inc. (HUM), which has risen 12% YTD. Bank of America Securities analyst Joseph France recently raised his price target on Humana to $95 from $85, and increased his 2008 per-share estimates to $5.50 from $5.40 per share. France said the company is historically conservative with its Medicare guidance, noting it has beat its initial annual estimates by an average of 35,000 members since 2005, which means the company could report better-than-expected results. Another positive catalyst is that it will be at least three years until Congress can make any cuts in Medicare Advantage programs. Under Medicare Advantage programs, the government pays insurance companies for taking on the risk of covering the health needs of elderly patients.

Outlook: Positive

Agriculture

There are two main drivers in supporting high grain prices: rising income and improving diets in emerging markets, which translate into increased demand for meat, dairy and animal feed. Furthermore, global demand for cleaner biofuel is also on the rise. As the result, agriculture-related stocks such as the world’s largest fertilizer maker Potash Corp (POT)., seed maker Monsanto (MON), and agricultural equipment maker Deere (DE) rallied nicely in 2007. Although their growth story and fundamentals remain intact since the bulk of their growth comes from outside the U.S., these stocks have plunged along with the broader market. I view this as a buying opportunity at a reasonable valuation for long-term investors. There are two ETFs that investors can conveniently choose to ride the long-term agriculture boom. The first one is Market Vectors Global Agribusiness ETF (MOO), which attempts to replicate the performance of the DAXglobal Agribusiness Index, 40 companies worldwide engaged in the agriculture industry. Another way is through agricultural commodities ETF PowerShares DB Agriculture Fund (DBA), which tracks the Deutsche Bank Liquid Commodity Index. It holds only corn, soybeans, wheat and sugar futures, split nearly equally among the four.

Outlook: Positive

Details of S&P 500 operating earnings by sector can be downloaded here.

Disclosure: The author is long on MOS and POT.

Comments

[User 140368]

would more like to know about housing in us

[ElliotMiller]

I cannot imagine the outlook for the health care industry being positive if the Democrats control the White House as well as the Congress.

[Georealist]

Wow..John J Hill of the least respected Bank in captivity targets (average..low???) gold at $710..so..after testing (another wonderfully vague term) the $1000 mark..whoosh...it will drop back $300???
Thanks also for your penetrating assessment Ari...hope you didn't lose much sleep researching such gems to share.

[Ari]

For Georealist:

Thanks for your comment. This is based on his report in early January, and I'm sure that there will be upward revision on analyst estimates in general.. Attached is the link to Institutional Investor's (I'm not saying it's the most accurate measure of analyst performance, but it is a prestigious industry benchmark) rankings of top Metals and Mining analysts:

www.iimagazine.com/Ran...~categoryId--13__part-...

starmine.com is also a great resource to learn about top analysts.

Let me know if you have further questions.

[lefty]

Consumer spending is 70% of the US economy. Until we put disposable incomeback into the general public housholds, there will be a recssion.
P.S. temporary tax rebate is jst a band aid. As for investing, the place to be is in the necessities. When I get my rebate, I may buy a WII.