Most equity managers are expecting a soft economy in 2008, but how sluggish it will be is subject to disagreement. Some say a recession is a distinct possibility. Many say U.S. stocks will outperform bonds, but not foreign stocks. Furthermore, they add investors can't depend on a presidential election year for sizzling stock market gains this time around.

Jeffrey Hirsch, based in Old Tappan, N.J., and editor of the Stock Traders Almanac, says election years have a modestly positive influence on stocks. Nevertheless, investors have to worry about market declines after the forthcoming 2008 election. "Priming the pump" by incumbent parties has tended to prop up market gains in election years. Since 1950, the S&P 500 has only had one loss in the last seven months of an election year and that was in 2000 when the tech bubble was imploding and the election turned out to be the most contested in 125 years.

Any severe declines, or bear markets, likely will be staved off until postelection 2008, or until the midterm 2010 election, Hirsch predicts. "In the last 50 years, election years have ended lower twice in 11 occurrences with an average Dow gain of 9.2%," Hirsch says. "Over the same 50 years, 15 bear markets have occurred. Four (1960, 1968, 1976 and 2000) have commenced in an election year. Just three (1960, 1980 and 1984) have ended in election years."

So if financial advisors can't count on the presidential election to prop up stock prices, what's in store for 2008?

If the economy slows, the Fed might cut interest rates, but don't expect any fiscal stimulus from Washington. That could spell trouble, says William Handorf, finance professor at George Washington University in Washington, D.C. "Congress and the administration have not focused on recent economic developments and will be unlikely to offer substantive fiscal relief as the 2008 presidential election nears," Handorf says. "Employment trends, retail sales and housing market developments will affect future monetary actions."

Inflation, however, is not out of the picture. Some economic reports indicate that the Producer Price Index could be up 6% in 2008. That, coupled with a falling dollar, means that inflation could become a concern. Plus, the Fed faces a challenge shoring up confidence in the financial markets without igniting inflation. With the Fed's recent focus shifting towards maintaining stability in the financial system, some analysts say investors may want to add an inflation hedge to the bond portion of their investment portfolios.

Bob Doll, global chief investment officer with BlackRock Investments In New York, notes the housing industry recession is spilling over into consumer spending, which often suffers when people don't buy homes. Retail sales have been falling.

However, energy, technology and telecommunication stocks should continue to perform well. Doll expects slower U.S. economic growth in 2008. But overall global economic growth is strong. That, coupled with a weak U.S. dollar and lower U.S. interest rates, should help U.S. exports.

On the fixed-income side, he says the Fed could be more hawkish on interest rates. Even though core inflation is within the Fed's comfort zone, concerns remain about high labor costs, elevated energy prices and the prospect of higher inflation expectations. "Despite concerns over economic growth, [stock] markets have continued to grind higher, and we believe that the bull market should continue," Doll says. "An environment of Fed easing and a weaker dollar should translate into continued price appreciation, provided that corporate earnings do not implode."

Another optimist is Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton School of Finance. Siegel believes the worst is over regarding the credit crunch and problems in the subprime loan market. "Everyone is going to say that there is going to be a big bomb and there is going to be a hedge fund that is going to go under," he says. "We haven't heard of any big bombs and things are slowly returning to normal."

Siegel believes we are in a mid-economic-cycle slowdown similar to 1995. After the Fed cut rates dramatically in 1994, there was a big economic slowdown, but no recession. Our economy, he says, is suffering from the fallout from a rise in rates and the excesses caused by rates being low for a long time.

He predicts 1% to 2% real growth in U.S. GDP. Housing is still bad and will remain bad, he says. But we've gone through a year of bad housing and managed to stay above water. "I think that will continue in 2008-and then looks better towards midyear and further beyond," he says. Siegel pegs the probability of a recession at 25%.

Jim Swanson, chief investment strategist at MFS in Boston, believes stocks will outperform bonds next year, but not by much. Earnings are slowing, and the U.S. Congress may want to raise tariffs on imports and taxes on stocks and dividends. He thinks municipal bonds could be a strong investment next year. "Municipal bonds trade at 95% of equivalent taxable bonds," he says. "Tax-free bonds will be more valuable if ordinary income tax rates go up. That makes tax-free bonds, which are already cheap to the bond market, even more valuable."

Swanson expects stocks to gain about 4% to 6% in 2008. Meanwhile, the MSCI EAFE stocks should grow at 8% to 10%. Reason: He's forecasting U.S. real gross domestic product (GDP) to be just 1.7% in 2008 while the rest of the world grows about 2.2%. Large-cap growth stocks will be the best-performing sector in the U.S. market-particularly hard and soft technology companies, he says. Large-cap stocks, which perform best later in the economic cycle, are profiting from overseas business in local currencies. Meanwhile, their costs are lower, since they are based on the U.S. dollar.
Small company stocks, however, could languish. Smaller companies are more tied to the domestic economy, which is expected to weaken. Swanson doesn't expect the housing sector to rebound anytime soon. This will slow economic growth in the United States.

And some predict oil prices are expected to drop to the $60 to $70 per barrel. However, Swanson thinks that if some country takes out Iran's nuclear program Iran will retaliate and take out some of Iraq's oil fields, which would drive oil prices higher. "Oil could go to $100 a barrel and the price of gas will hit $5 per gallon," Swanson says. "That can put us in a recession with higher inflation."

Meanwhile, Robert Arnott, manager of the PIMCO All Asset Fund, is concerned corporate earnings have peaked. The Reason: Earnings are 60% above the 10-year average, and Wall Street is calling for an 8% annual earnings growth rate for the foreseeable future. There is no historical precedent for that type of growth off of peak earnings. "It's our expectation that earnings will struggle in the next two years," he said. "Wages as a percentage of GDP are the lowest in history. Corporate profits as a percentage of GDP are the highest in 30 years. If earnings grow rapidly from current levels, political repercussions could be daunting."

Come the second quarter in 2008, Arnott says the volume of subprime mortgages being reset away from teaser rates will peak. All this translates into either a sharp slowdown or mild recession. "The bond market is priced to reflect that expectation," he said. "The stock market is not. When stocks and bonds disagree, usually bonds turn out to be right."

Arnott says inflation and interest rates should remain relatively stable. His biggest concern: Congressional protectionist measures that could change the way we deal with our trading partners. For stocks, he would favor companies with a value orientation, and low price-to-earnings and price-to-sales ratios. "That would point away from growth sectors like technology," he says. He also favors increasing local currency emerging-markets debt, which he considers both yield and currency plays. Such a strategy, he says, offers good prospects for high-single-digit returns at a time when most markets are expensive.

Liz Ann Sonders, chief investment strategist at Charles Schwab, San Francisco, is cautious. The reasons: Housing problems have not hit bottom and employment is weakening. Threats to consumer spending also put the economy and stock market at risk. And if the United States goes into a recession, emerging-market stocks will decline because these countries are too dependent on exports, she warns.

Overall, she sees about a one-in-three chance of a recession in 2008. Corporate balance sheets are solid, she says, but business confidence is declining. "We consistently recommend rebalancing periodically to bring allocations of stocks, bonds and cash back in line with long-term targets," she says.

John Mauldin, president of Millennium Wave Advisors and publisher of Frontline, an online report, believes the United States will experience a "slow motion recession" due to the housing market. Typically, he says, a recession leads to a bear market with an average decline of 40%. However, this time around, stock market losses will not be that bad because large multinational growth companies are getting as much as 50% of earnings overseas.
"I expect the U.S. economy to grow below trend for most of 2008," Mauldin says. "The continued fall of home prices will take a toll. Since it will play out over most of next year, it will be a drag on growth for quite some time. It will have an effect on earnings, although companies with international exposure may do well as the rest of the world continues to expand and the dollar weakens."

Not all large company stocks necessarily will benefit from the global economic boom, says Edward Yardeni, president of Yardeni Research in Great Neck, N.Y. Materials, energy, industrials and information technology will benefit from global economic growth, he says. These industries account for more than 40% of the earnings and 40% of the market-cap shares of the S&P 500.

But financial advisors should not count on the financial and transportation sectors to perform as well. "Can the stock market [S&P 500] rise into record territory if financial and transportation languish?" Yardeni asks. "No way. I see one way this can happen: if industries and stocks that benefit from the global economic boom continue to gain earnings share and market-cap share in the S&P. That's a tall order. Financial and transportation together account for 28% and 21.8% of S&P 500 earnings and market-cap shares." Areas of strength he sees in U.S. stocks include energy, aerospace, defense and machinery industries. Also, the service sector has been providing the bulk of the job gains, led by health care, hotels, restaurants and professional and business services.