Where Things Are Headed in 2008

That mistake looms larger now that the dollar is sliding, the U.S. economy is soft, and global growth is robust. This is the time to bone up on foreign securities and reallocate that 401(k). Also: Stash money in Treasury inflation-protected securities in case inflation accelerates.

Challenging times favor investors who focus on companies with abundant free cash flow. Such companies can survive even if debt markets shut down and no one wants to buy their equity. Seek stocks whose prices are justified by solid, ongoing businesses rather than market speculation about riches to come. William W. Priest, CEO of New York’s Epoch Investment Partners (EPHC), says stockpickers have to understand companies’ competitive positions, not just how they stack up by accounting metrics. More than ever, "a business analyst is worth a lot more than a financial analyst," says Priest.

Financial leverage has gone from being the key to wealth to a big fat mistake. When lending was still lush, investors accepted thin premiums for buying the securities of riskier firms. They rationalized that they could sell out whenever they needed to. What’s clear now is that "liquidity that looks great on Monday can be gone on Wednesday," says Marc D. Stern, chief investment officer of Bessemer Trust in New York. Stern considers the current retrenchment "a healthy correction to a period of a great deal of excess." His picks include health-care stocks, tech firms that have a big share of their sales abroad, and Asian markets such as Singapore, South Korea, Malaysia, and Japan that do business with booming China and India but have lower p-e’s than those of the twin giants.

ONLY WAY IS UP?

Still, there’s a bullish case to be made for U.S. stocks in 2008, if the economy manages to dodge a recession. For one, strong growth abroad could help prop up earnings. 3M (MMM), for example, forecast on Dec. 12 that its earnings per share in 2008 would rise by 10%, thanks in part to emerging markets.

Meanwhile, the Federal Reserve will probably cut rates further if the U.S. economy continues to weaken, which could give stocks a shot in the arm.

There could be more fiscal stimulus, too, if the White House tries to amp up growth ahead of the 2008 Presidential election. Here’s a bit of trivia: According to Stock Trader’s Almanac 2008, the Standard & Poor’s 500-stock index has risen in the final seven months of every election year since 1950 except one.

And optimists dispute the notion that U.S. consumers are bound to quit in 2008. "When Americans are happy, they spend money. When they are depressed, they spend even more money, as long as they aren’t losing their jobs," writes economist Edward Yardeni, the president of Yardeni Research.

For some stock market bulls, the best news for the market is investor pessimism. The p-e ratio for the S&P 500 based on trailing 12-month earnings is just over 18, vs. well over 25 in 1999 and 2000. That means that on average, investors are paying moderate prices for companies generating respectable profits. The UBS (UBS) Index of Investor Optimism plunged 26 points in November, to 44, which was the lowest since right after Hurricane Katrina. Once everyone has capitulated, the contrarians figure, there’s no one left to bail out, and stocks have nowhere to go but up.

If you buy the bullish case, you might consider buying beaten-down banking stocks, which offer attractive dividend yields at current prices. The trick is figuring out which banks have already come clean on their loan losses and which ones haven’t.

Still, no one knows how much farther the housing market will fall, and this factor will determine how much damage the financial sector and the economy are going to have to absorb. Under these conditions, betting on the stock market is a high-risk proposition. It’s hard to get too excited about the 2008 outlook when the most positive thing you can say about the year is that (to quote the contrarians) everyone has given up on it.

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Coy is BusinessWeek‘s Economics editor.