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Top Ten Predictions for 2008

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January 3, 2008

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2007 is over and it was a watershed year in terms of an investment landscape momentum shift. The year started out with vast "liquidity" and assets of all types continuing their rise and ended with a mortgage market in complete disarray, no "liquidity" and an increasingly impaired banking system. However, through it all, the major US stock averages managed to rise. I have been counseling "defense" since the beginning of 2006 and was wrong about the market averages going up (although I believe correct to focus on higher-quality issues). My caution on the US stock market is all about perceived value-there are those that can argue otherwise but a P/E of 16 and a dividend yield of 1.85% (rough figures for the S&P) is not a compelling long-term value to me. In a world where capital is increasingly scarce and risk of many other types is being repriced, a correction is long overdue. Increasingly expensive overseas markets which are reliant on exports to America don't look that great to me either.

On page 69 of One Up On Wall Street, Peter Lynch said that "the actual behavior or stocks, [which] is more simple-minded than they can imagine". My moniker for 2008 is "keep it simple (minded)". The housing market is in shambles, corporate profits are headed down, the dollar is weak and the banking system is impaired. Regardless of whether you think you see value in stocks now, the trend is down and that is where asset prices are headed. Do yourself and a favor and, unless you are tremendous expert, stay away from investing in complicated situations. If you think you see value, breath easy and wait for lower prices. Then, do it again and again and again and again (after about the fifth "value opportunity", you can jump in). Favor simple, obvious values with clean balance sheets or stick your money in cash and you should outperform. 2008 is going to be a tough year for asset prices.

Without further ado, here are my fearless 2008 predictions:

1. Housing Prices Take a Record Fall as Housing Problems Go National; the Case-Shiller Home Price Index Falls More than 10%

The rate of change in housing prices should be the greatest in the middle of the time period between top and bottom and I believe that 2008 will fall in the middle of that period. In retrospect, the housing market topped in 2005 and has fallen gradually since then. Now that we are clearly going down, expect the rate of change of price changes to accelerate. Consider what has been happening so far: sellers have been reluctant to drop prices too much as they anchored themselves to the boom time, the classic "stickiness" to the housing market. So far, outside of the most speculative markets, it has been sales volumes, and not prices, which have taken the biggest hit. As sellers now need to sell, they will have to lower their prices dramatically to make sales. If you throw in a dead mortgage market and jumbo mortgage weakness, the high-priced coastal markets are headed for a serious fall. As this plays out, expect the Alt-A and jumbo markets to tumble. Since these are dominated by portfolio bank lenders, expect further deterioration of bank shares.

Investment Thesis: Do not buy any "dips" in houses or real estate. Stay away from bank stocks with exposure to real estate.

2. US Stocks Drop Low Double Digits in Value.

Our country's housing problems are going to lead to a serious economic slowdown (if not recession) in 2008. The overextended US consumer does not have the household balance sheet to continue spending in this type of environment and this is going to slow the economy and hit corporate profits. All of that is bad for stock prices which, as discussed above, are probably overvalued anyway. When you add it up, the long awaited correction is coming.

Investment Thesis: Sell consumer oriented issues. Don't "bottom fish" in the financials. Favor high quality, special situations with strong balance sheets.

3. Emerging Markets Stocks Break their Winning Streak

Let's face it-emerging market stock prices are now no longer cheap either. With a slowing world economy and no obvious catalyst for continued equity appreciation in the emerging markets, those supercharged markets (e.g. BRIC) will finally fall back in 2008. Towards the end of the year, there will be increased talk about a slowing Chinese economy.

Investment Thesis: Book gains in emerging market shares.

4. Mortgage Backed Securities Market Collapses but value emerges in Q4

Mortgage Backed Securities will continue their decline as fundamentals continue to decline and loans reset. A fall of housing prices will be the final kick in the gut. A selling climax will be reached sometime in Q4 when value (perhaps driven by political events) will begin to emerge.

Investment Thesis: Avoid MBS, banks or mortgage companies. Look for value in mortgages (note: not housing) in Q4.

5. Illiquid Assets Continue to Lose Value and Volatility Continues to Rise

A by-product of the impaired nature of banks and brokers balance sheets will be a fall in the process of illiquid assets which will no longer be as easy to finance. Part of the problem in the subprime mortgage market is the illiquidity of the private label mortgages. Here's an illiquid asset that I believe is at or near a top a price top: sports franchises. The fundamentals are bleak (high operating costs, weak demand amongst younger Americans, poor and overpriced product). I believe Sam Zell's sale of Chicago Cubs will mark a top in sports franchise values. I am sure you can think of many more similar markets. Volatility will increase in the stock market.

Investment Thesis: It may sound boring but stick to plain vanilla assets. Consider trading more to benefit from price fluctuations.

6. Spreads in Mortgage Backed Securities, Mortgages and Corporate Debt Widen

At their heart, CDOs and their related "structured product" vehicles are spread tightening trades as investors seek to arbitrage the difference in liability costs versus the amount the underlying assets yield. As the supply of CDOs diminishes, that eliminates a significant spread tightening bid on these assets. That means as fundamentals weaken, we should expect significant and swift widening of spreads. I expect MBS "subprime" spreads to be very wide in 2008, "jumbo" and Alt-A spreads will also be very wide and corporate (e.g. high yield) spreads will widen.

Investment Thesis: Focus on higher quality bonds. Do not chase yield.

7. Commodities and Oil Outperform on a Relative Basis

Commodities have had a tremendous run and I expect them to continue to outperform although I am not sure how much prices will actually increase in 2008. The outlook for oil and natural gas, precious metals and agricultural commodities looks strong. On the other hand, certain industrial commodities (aluminum, iron ore) look as though they have hit a near-term top and increased supply may cause prices to fall.

Investment Thesis: Do not be scared out of commodities. Consider adding commodity exposure on weakness.

8. Fed Funds Rate Falls to 3-3.25%; Long Rates Rise Slightly; Short Term LIBOR Falls But Remains Above Fed Funds Rate

The Fed will maintain its weakening bias and I expect 100 to 125 basis points in further cuts in 2008. However, the massive bid that the banking sector as put on short-term Treasuries versus LIBOR assets will begin to subside.

Investment Thesis: Treasuries are unlikely to deliver much return from these levels. Funding will loosen a bit and short-term based LIBOR instruments (such as short term bank funds) might be amongst the best bond investments.

9. Dollar Holds Its Own Against Euro Currencies; Asian and Latin America Currencies Perform Best

The dollar has been a great punching bag for the last 5 years or so and it does indeed have many fundamental problems. However, a slowing world economy, an aging population and high energy and commodity prices are problems for the rest of the world too. Europe looks increasingly vulnerable with several major economies (Italy, Ireland and Spain) weakening. The UK is very reliant on finance and could have issues as well. In 2008, the Asian and certain Latin American currencies will perform the best.

Investment Thesis: Long Aussie dollar, New Zealand dollar, Japanese yen, New Taiwan dollar and Mexican peso. Short Euro, pound and US dollar.

10. Changes in US coinage are made or announced

Currently, based on metal content and even after base metals fell in price during the second half of the year, the nickel is worth more than $.05 and the penny costs more than $.01 to make (see For a government that needs to balance its budget, this is too tempting an area to cut. Long-term, I see the penny being eliminated and the nickel either reconstituted or eliminated. We may eventually reconstitute around four coins: dime, quarter, half-dollar and dollar or nickel, dime, quarter and dollar.

Investment Thesis: It's going to be hard to make much out of pennies or nickels but consider hanging on to your nickels for fun as they eventually will have numismatic or metal value that exceeds $.05.

As always, have a great year and happy investing!