Stock Market Shows Resilience In a Year of Economic Turmoil
Analysts Predict Continued Growth and Volatility in 2008

By Tomoeh Murakami Tse
Washington Post Staff Writer
Tuesday, January 1, 2008

NEW YORK, Dec. 31 -- After a year of stomach-churning swings, U.S. stocks managed to finish 2007 with a modest gain despite a worsening credit crunch and concerns about an economy possibly headed for recession.

When the final bell rang Monday on Wall Street, the Dow Jones industrial average of 30 blue-chip stocks stood at 13,264.82, up 6.4 percent for the year. The broader Standard & Poor's 500-stock index closed at 1468.36, up 3.5 percent for the year. The tech-heavy Nasdaq fared best, finishing at 2652.28, up 9.8 percent. The S&P has now finished with a gain for the fifth year in a row, although this year's advance is much smaller than last year's 14 percent rise.

"It was a mixed year at best," said Sal Morreale, a trader at Cantor Fitzgerald.

Stocks started 2007 with a brief rally but plunged in late February, with the Dow shedding 416 points in one day as concerns about subprime mortgages swept through the market.

Within weeks, investor optimism about a strong global economy and solid domestic employment began pushing shares higher. On May 30, the S&P 500 hit an all-time high, surpassing its record reached at the end of the tech bubble seven years earlier.

Shares continued to climb for a few months, although quarterly corporate earnings growth slowed to single digits for the first time in four years. At the same time, signs were emerging that an increasing number of Americans were struggling to make payments on their mortgages. Wall Street investment banks had pooled billions of dollars of these mortgages, packaging them into securities sold to investors around the world.

The stock rally, analysts said at the time, was in part prompted by a lack of investing opportunities elsewhere; a low-interest-rate environment had diminished returns for money markets, bonds and other non-stock investments, and a global financial system awash in cash meant investors in high-risk assets such as corporate junk bonds and subprime-mortgage securities were getting only modestly better returns than those invested in safer assets.

But all that changed almost overnight in mid-summer with the subprime problem morphing into a full-blown credit freeze.

With fear taking hold, investors sold off risky assets of all types, fleeing stocks and funds that sometimes had little to do with the troubled U.S. housing or mortgage markets. Money managers faced massive withdrawals. Central banks in Europe, Asia and the United States pumped tens of billions of dollars into the financial system, as the cost of borrowing rose for many consumers and companies.

Volatility returned in full force. Shares of automakers and companies that produce household goods, textiles, clothing and leisure equipment were beaten down as investors doubted the ability of consumers, who fuel two-thirds of the economy, to keep spending.

Financial shares took a brutal hit as their earnings outlook clouded. The lucrative business of selling mortgage-related securities was over, as was the leveraged-buyout boom that had driven Wall Street banks to sell hundreds of billions of dollars in debt to yield-hungry investors.

Leveraged buyouts, in which acquiring firms typically pay hefty premiums to take public companies private, slowed sharply in the second half of the year. A total of $25 billion in deals were announced in the fourth quarter in the United States as of last Thursday, down 85 percent from a year earlier, according to Dealogic, a data-research company.

Although the stock market gain was meager at best, analysts and traders noted that initial public offering activity was high, share buybacks were at record highs and investors in certain sectors were handsomely rewarded.

"You had oil prices go through the roof, and you had the subprime problem hit," said Andy Brooks, head of stock trading at the Baltimore brokerage T. Rowe Price. "In light of the challenges . . . I think, frankly, the market's done well."

Helped by record oil prices, companies in the energy sector fared best in 2007, gaining 32.4 percent. The materials sector, buoyed by rising commodity prices, also did well, advancing 20 percent. By comparison, the financial sector lost 20.8 percent, while consumer discretionary shares shed 14.3 percent.

Without financials, which make up 20 percent of the S&P 500, the index would have gained more than 10 percent for the year, said Howard Silverblatt, a senior index analyst at Standard & Poor's. Companies in the index, Silverblatt said, bought back an estimated $586 billion in shares in 2007, up from $431 billion the year before. They were able to do so in part because of their strong balance sheets. Excluding the financial and utilities sectors, companies in the S&P 500 have $623 billion of cash on their books, Silverblatt said.

In the coming months, investors will be watching the housing market, consumer sentiment, employment numbers and earnings from major Wall Street firms to determine where the stock market goes from here. Although consumer spending has remained surprisingly robust, any weak jobs data is likely to send a nervous market spiraling downward. Billions of dollars in additional losses are expected at investment banks in early 2008, and that could get a lot worse if the housing and mortgage markets do not stabilize, analysts say.

Kevin Shacknofsky, a portfolio manager at Alpine, said stocks were not overpriced, trading at about 15 times the expected earnings for 2008. In addition, Shacknofsky said, the Fed should continue to cut its short-term interest rate, which generally helps stocks. He predicts a double-digit rise in the market in 2008.

Despite reduced liquidity, or ability to trade assets easily, there is no shortage of capital, Shacknofsky noted, pointing to foreign governments in cash-rich Asian countries and the Middle East that have invested billions of dollars in faltering U.S. financial companies.

"There are a trillion dollars of sovereign wealth funds searching for a home," he said. "The capital is available. There just needs to be a confidence to invest it."

In the meantime, analysts said, investors should expect continued volatility in the stock market as the financial system works through uncertainty about further damage at the nation's big banks and looks for the bottom in the housing market.