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Tuesday, 18 December 2007

Outlook for 2008: Markets and the Economy

by Jeremy Siegel, Ph.D.

It’s time to dust off the proverbial crystal ball and predict what’s in store for 2008. But before doing so, let’s see how I did with last year’s forecast.

Well, I was pleasantly surprised to see that I got quite a lot right despite missing the subprime crisis. I predicted that the economy was poised for a mid-cycle slowdown, similar to what we experienced in 1995, the year after the Fed had also raised rates. I predicted GDP growth would slow in 2007 to 2½% to 3%, and despite the credit crunch, this estimate was very close. Even if this quarter’s GDP grows by a measly 0.5%, GDP growth for 2007 will be at 2.5%.

For the US stock market, I predicted an 8% gain and greater gains for foreign markets. December still has two weeks to go, and given the recent volatility, the market could end the year anywhere. But as of now, the S&P 500 Index is up 6.3%, while foreign markets have done significantly better. The foreign developed markets, represented by the EAFE Index, have returned 15.6% and the emerging markets continue their torrid pace, chalking up a 42% gain. Last year, I said that if US stocks climbed less than 8% in 2007 it would be due to $3 a gallon gasoline and the dollar falling below $1.45 per euro.

Subprime Crisis

Both barriers were breached, but the main reason for this year’s stock market malaise was the credit crisis, which, despite my bearishness on real estate, I didn’t see coming. I’ve written a fair amount about this crisis on Yahoo! Finance and downplayed its importance to the overall economy. Why? I never expected the fear of debt defaults to so swamp the reality of this problem.

I think the actual number of delinquencies next year will be below what the market predicts, as investors have overreacted to the mortgage crisis. When this happens, it could lead to a nice recovery in financial stocks.

Economic Growth

But the impact of the crisis on the psychology of consumers and business will leave their mark. I predict that GDP will slow in the first half of next year to between 1% and 2%, and rise in the second half, as risk premiums come down and the cost of capital falls. Overall I expect 1.5% to 2.5% GDP growth in 2008 and I believe the economy will avoid a recession.

Stocks and Bonds

I think the stock market will have another winning year in 2008. For every percentage point that stock returns fall below 8% (my prediction) this year, they should exceed 8% next year (meaning, for example, if stocks gain 6% this year, they should finish 2008 up 10%).

And I believe that financial stocks, which have plummeted 18% so far this year, will outperform the S&P 500 Index next year as the credit crisis fades.

Interest Rates

What does all this mean for interest rates? The Fed cut the Fed funds rate to 4.25% on December 11, but it will have to do more in the coming months. I believe that the Fed will get rates down to 3.5%, before ratcheting them upward in the second half of next year.

Treasuries did well in 2007, as interest rates on top-rated securities plunged in light of the credit crisis. But as the risk spreads narrow, money will flow away from government bonds and their interest rates will rise. I recommend investors cash in governments and top rated corporate bonds now – you got a nice ride that you won’t get next year.

Oil

There are always events (or “risks” as Wall Street calls them) that can upend these forecasts and oil is always one of them. Despite some promising political developments in the Mideast, history has taught me to be cautious.

If oil surges past $100 a barrel for whatever reason, we will be in trouble. Three dollar gasoline did not prove to be the tipping point for the consumer in 2007. But with a weak housing market, I believe $4 gasoline would do considerable damage to consumers’ pocketbooks in 2008. And $4 gasoline would happen if oil rose to $120 a barrel or higher.

Politics

Of course, next year is a presidential election. Although the primaries appear up for grabs now with Barack Obama and Mike Huckabee making a good run, I believe that the Democrats and the Republicans will nominate front-runners Hillary Clinton and Rudy Giuliani. After a hard fought battle, Hillary will pull through as the electorate seems ready for a new party to govern from the White House.

Since I predict the Democrats will also keep the House and Senate, a Democratic sweep will send some nervous flutters through Wall Street. But Clinton will prove to be as moderate on economic issues as was her husband. This means that although taxes will rise on dividends and capital gains when the current low rates expire in 2010, the increases will be moderate and Wall Street will be relieved.

I’ll wait until after next year’s election before offering up another set of projections for 2009. In the mean time, have a healthy and prosperous new year!

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