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Briefing.com Outlook for 2008
Outlook for 2008
Last Update: 02-Jan-08 08:33 ET
Our Track Record and 2008 Outlook
The past year was volatile for the stock market, but the S&P 500 index ended up near our original expectations. The outlook for 2008 is for another year of a low single-digit gain. The stock market may underperform historical trends for the next few years.
The Past Five Years
The Big Picture has presented a specific year-ahead outlook each year since 2004 and a general view in 2003.
Below are our forecasts and the ultimate increases in the S&P 500 index. Links to the full column with detailed analysis are presented.
Year Forecast Index Change Column
2003 Mod. Bull 26% January 22, 2003
2004 7% to 10% 9% January 4, 2004
2005 5% 3% January 3, 2005
2006 3% to 7% 14% January 3, 2006
2007 5% 4% January 3, 2007
The stock market has been on a good run. For the four years from 2003-2006 in aggregate it outperformed the long-term historical averages for the stock market.
In 2007, it underperformed the long-term historical performance for the stock market.
That is likely to be the case again in 2008, and perhaps for the next several years.
The Economic Outlook
Whether the economy will enter recession is the major question facing the stock market.
We have stated our view on numerous occasions that the economy will avoid recession. Our most recent analysis was posted in the Big Picture column of November 26.
To summarize, while the housing slowdown is severe and will continue in 2008, the impact will not be as widespread as commonly feared because it will not cause a significant cutback in consumer spending or a credit crunch.
Housing prices have declined for two years already and there has not been a major impact on consumer spending. A third straight year of 5% price declines will not suddenly cause consumers to quit spending their income.
The liquidity problems in the credit markets will also not cause a recession. The write-down in value of mortgage securities is a severe problem for financial firms, but there has yet been no cutback in bank credit. In fact, commercial and industrial loans have risen at a 30% annual rate since July, when the credit problems started surfacing. Real estate loans are up at about an 8% annual rate. Credit is still being extended. There is no credit crunch.
Furthermore, the Fed is well ahead of the curve relative to previous recessions in addressing the issues that the economy faces. They began cutting rates with a discount rate cut in August. The fed funds rate has come down 1% to 4.25% since the first rate cut in September.
Fourth quarter real GDP growth will be near 2%, yet the Fed has already cut rates a number of times many months before any downturn in GDP. This will help support the economy in 2008. This was detailed in our December 24 Big Picture column.
None of this means economic growth will be strong in 2008. It clearly will not be. Growth will be very sluggish and below a 3% real growth rate in the first half of the year, and perhaps all year.
That is only one reason, however, that the stock market will struggle.
The Earnings Outlook
The problem for the stock market is that earnings growth the next several years will be below long-term trends.
The strong stock market gains from 2003-2006 were due to very strong growth in profits.
Profits rose at a 17% average annual rate for the four years through 2006. These large gains were due partly to strong economic growth but even more so to sharply rising profit margins. In fact, profit margins have recently risen to near record levels.
Now, profit margins are likely to drift toward their long-term norms because of competitive and political reasons.
This was discussed in detail in our two piece series back on February 20, 2007 and February 26, 2007. Corporate profits as a percentage of GPD have reached 12.5%. The long-term average is closer to 10%. Assuming that percentage drops back to 10% over the next five years, revenue growth of 5.5% at the S&P 500 in aggregate will lead to just 1% annual profit growth.
Declining profit margins will create an uphill battle for profit growth the next few years.
Interest Rates, the Fed, and Valuation
There is good news here. Interest rates are low and will stay low. Valuations are reasonable. This reduces the downside risk to the stock market. It may even be that there will be some modest multiple expansion over the next couple of years.
The price/earnings multiple (P/E) on the S&P 500 in aggregate for operating profits currently stands at 16.8 through estimated fourth quarter earnings (which include a lot more write-offs).
That is very reasonable given the current interest rates environment. In fact, the P/E hasn't moved much higher even with the decline in third quarter profits and an expected drop in the fourth quarter.
It is very possible that the P/E could settle in at approximately 17.5 over the next couple of years, which would provide some modest lift to the overall market even during a period of sluggish economic growth.
What it All Means
Economic growth will be sluggish in 2008 and perhaps into 2009.
Profit growth in 2008 will be limited due to the sluggish economic environment.
Even worse, profit growth will be constrained over the next few years due to a likely decrease in margins. Political pressures for redistributive policies could be a major factor.
Slow earnings growth, even with modest expansion in multiples, will limit the upside potential for the stock market.
Our forecast for 2008 is therefore of a low single-digit gain in the range of 2% to 4% for the S&P next year. We would not be surprised if the market averaged similar gains for a few years.
The market has outperformed historical trends from 2003-2006, and it may now slightly underperform for a few years.
Nevertheless, the current reasonable valuations limit the downside risk more than the excessively pessimistic tone suggests. Even if profits are flat for 2008 as a whole, the P/E would have to drop even further to cause a decline in the S&P for the year. The P/E would have to drop all the way to 15 to cause a 10% drop in the S&P index under that circumstance.
The range of possibilities in 2008 is larger than in recent years. Nevertheless, our view is that long-term investors will therefore continue to benefit from a better total return in the stock market than from alternative investments.
It won't be a great year for the stock market in 2008, but it won't be terrible either.
-- Dick Green, Briefing.com
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