2008 and the Rip Van Winkle Strategy:
Eight Reasons for Second-Half Growth and How to Stay Calm Until Then

By Ernie Ankrim, Chief Investment Strategist
Russell Investments

December 17, 2007

You've heard it before: "It's going to get worse before it gets better." Well, you're hearing it again - from me. The bad news: the economy will require antacids during the first half of 2008. But good news should follow: an improved economy and upturns in the markets starting sometime this summer or early fall. How to get through it? Look to Rip Van Winkle for inspiration. I'll explain why at the close of this column - by which time you may have figured it out.

First, a note about the ¼-point Fed Funds cut on December 11. It was what I was hoping for, although I wouldn't have minded a ½-point cut off the discount rate. What's important is that the Fed's strategy provides financial institutions with higher access to liquidity. This approach represents "good parenting" on the Fed's part even though investors wanted a bigger cut - the Dow ended down 294 points following the announcement. Like a parent, the Fed realizes that the kid in the back seat of your vehicle may whine and threaten to hold his breath unless you pull over and buy him an ice cream cone. You don't do it, because he'll always expect a payoff for whining. The Fed's gradual, modest approach should stall any significant inflation threat, and the markets will be fine, particularly if Chairman Ben Bernanke and I are correct that a recession isn't in our future.

So now, here's what I think you're likely to see so long as the numbers in my crystal ball prove to be as accurate as I expect.

1. We'll move from meltdown to liquidity. Yes, we'll see continuing uncertainty and sub-prime mortgage write-offs early in 2008. We'll also see a huge number of re-sets in adjustable mortgages through the middle of the year, and that will hurt. (Not to sound like Scrooge, but the only way to discourage people from taking on bad mortgages is to make it painful. If we let people hold on to teaser interest rates, who will learn a lesson?) However, we should see more transparency and finally liquidity for structured investments. Mortgage re-sets should diminish substantially in Q3 and Q4. And because lenders haven't generated dangerous sub-prime loans recently, we won't see a re-set problem in 2009. The markets should put some serious pain aside and celebrate this development, and the removal of uncertainty, as we head into the second half of 2008.

2. The "dead cat" won't bounce. Housing prices likely will decline through Q1 and Q2. Then, thanks to added liquidity, transactions will increase with people buying houses at discounts from original face values. This will help lenders make more loans. While prices will still decline, the drop should moderate heading into 2009. When and where will we find the bottom? Forget a sudden bounce. Corrections in '79 and '89 saw home prices decline between eight and fifteen months, hit bottom then stay flat for three to five years. That flat part will surprise many people going into 2009 and even 2010.

3. "Big Stocks Don't Cry." (My apologies to the Four Seasons, a great band of the '60s.) Large, internationally diversified companies should continue to outperform their smaller, domestically oriented siblings in the U.S. equity market for the second year in a row. Right now, the Russell 1000® is beating the Russell 2000® by 8½ percent, although I don't expect results quite that dramatic next year. Fears among lenders hurt small-cap companies more, which should contribute to smaller companies lagging behind.

4. Uncle Sam "cowboys up." The dollar's value should stop declining thanks to better trade numbers, continuing slower domestic growth, international investment in-flows, and expected monetary and fiscal restraints. I anticipate that Uncle Sam will get tough. The dollar has rallied strongly since mid-November, and this may be just the beginning - not of a real strong dollar but of a more stable one. As a result, overseas equity returns will more reflect market improvements than currency appreciation. Individuals diversifying their bond holdings outside the U.S. likewise shouldn't anticipate for a currency advantage.

5. That kid down the street sure is growing. Look for tighter monetary policies to take a toll on developed economies - U.S. and non-U.S. But while a global slowdown will take some steam out of developing economies, their growth rates will slow only slightly. I expect that going into Q1 and Q2, our GDP will be close to or less than 1%. Then we'll pick up in the last half of 2008 to take us to about 1.8%, which, to be sure, is really slow. Europe and England's growth rates probably won't decline as rapidly, but they'll start to slow. They're declining now. So the central banks in the European Union and England could consider a short cut to add liquidity. Emerging markets will also slow - but from 13% to maybe 10%.

6. High prices but no inflation. Commodity prices SHOULD remain high, but both commodity and broader price-level inflation should remain contained with oil staying under $100. What will hold inflation in check? First, increased global competition makes it difficult for firms to pass on cost increases to customers. Second, high commodity prices haven't yet created real inflationary pressure. If they remain stable, even at their high levels, we'll see zero inflationary impact on the economy.

7. "The sun will come out tomorrow!" (How can you not love this standard from "Annie?") An upturn in the economy in Q3 and Q4 should create optimism for 2009 - particularly after the election. Let me note here that it doesn't matter who wins. The market cares only that someone gets elected. Only a contested election - we've been there - would hurt. Renewed hope will cause earnings multiples on equities to rise ahead of anticipated positive developments. That will help equity returns approach the mid-to-upper teens in spite of slow 2008 growth.

8. We'll make it up on volume. I don't often make sector calls, but in the two previous downturns, homebuilder stocks did very well a year or so after the bottom in housing prices. Although home prices will remain weak and financing problems continue through early '08, homebuilder stocks should bounce back before the year ends. Here's why. Downturns produce declining prices for land, materials and labor. This enables homebuilders to achieve healthy margins and make money on homes more "modestly" priced homes. I think that before 2008 ends, we'll view homebuilder stocks optimistically - as long as we have no recession.

So let's look at the numbers - with a disclaimer. I'm writing about what I think will happen. Obviously, I can't promise that the economy and the markets will deliver. No one can. By my best judgment points to the following for 2008:

These views are subject to change at any time based upon market or other conditions and are current As of December 17, 2007. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

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