The Stress Is Just Beginning

With the Economy at a Crossroads, The Market's In for Big Shifts

NEW YORK

If the first three trading days of the year are any indication, 2008 is bound to test the nerves of even the most poised investors.

After the New Year holiday, the U.S. stock market reopened for business Wednesday with its worst first-day performance in years. Blame $100 crude oil and weak manufacturing data. A day later, a Commerce Department report showing a jump in factory orders buoyed investors, but on Friday the market was again slammed, this time on news of meager employment growth in December.

Dizzy yet? Expect more of the same, investment professionals said.

"You have oil near all-time highs. . . . The dollar's bouncing. Plus, you've got the elections," said Mark Coffelt, chief investment officer at Empiric Funds. "There's an awful lot of uncertainty causing markets to jump. I don't see that abating."

Investors went through the wringer in the second half of 2007, a lesson in learning to live with uncertainty. The economy, meanwhile, was swatted by the housing downturn and the credit crunch and appears to be slowing. The fortunes of the stock market this year hinge on what lies ahead for U.S. growth, analysts said.

The economy stands at a crossroads, economists said. One path leads toward growth below historical trends for several quarters before consumers help fuel a recovery. A solid job market would underpin consumer confidence. In this scenario, the housing downturn would finally bottom out as the market begins to experience the positive effects of lower home prices and a tightening of lending standards. Credit markets would stabilize. Beaten-down market sectors, such as financial stocks, would start to get snatched up as bargains.

The other path is much more perilous. In this scenario, more surprises are in store for the credit market, and financial institutions hold back on lending and impair the business investment necessary for growth. Higher consumer prices would tie the Fed's hands, making interest rate cuts difficult for fear of stoking inflation. Corporate profits would be squeezed, hurting stocks. Companies would accelerate layoffs, shutting down consumers who aren't as able to spend freely on debt but who have to pay more at gas stations and grocery stores. The economy would fall into recession.

"The biggest challenge is consumer spending," said Christopher Low, chief economist of FTN Financial. "Consumers have been excessively reliant on debt, and debt is a whole lot harder to come by." Consumer spending accounts for two-thirds of the U.S. economy.

Until investors are comfortable with the direction of the economy, volatility will reign, analysts said, with nervous market participants reacting to each bit of economic data and corporate earnings news.

The current tumult -- a legacy of the credit mess that shook financial markets around the globe in the second half of 2007 -- has prompted shifts in several investing trends.