Global Outlook—January 2008

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The 2008 outlook for global equity markets is binomial, in my opinion, with two possible outcomes that depend on whether the economy grows at a below trend rate or falls into recession. If the economy avoids a recession, the S&P 500® Index¹ would likely perform well in an environment characterized by 7-10% earnings growth, lower interest rates, increased liquidity from additional Federal Reserve (the “Fed”) rate cuts, a steeper yield curve that would bring profitability back into the financial sector, and possibly a stronger dollar. Price-to-earnings multiples would likely expand as well, providing an additional boost for the equity markets under the above scenario.

However, recent economic data announcements have pushed the odds of a recession to levels that can no longer be ignored. The most troubling data point, I believe, is the increase in the unemployment rate from 4.7% to 5.0%. In the past, a 0.3 percentage point increase in the unemployment rate in a 90-day period has always led to a recession within 7 to 9 months. A 0.5% increase means a recession has already arrived. I believe the unemployment rate will be above 5.3% by summer. Other data also worth considering include an inverted yield curve (as measured by federal funds/10-year Treasury note yield), which, with the benefit of hindsight, has been a reasonably early warning sign. The curve inverted in July 2006. The current 25% decline in year-over-year starts in single-family homes is on par with a magnitude that has led to a recession in six of the last seven cycles. The Conference Board’s coincident-to-lagging indicator is 96.08, a level that, in the past, has 1 The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The index does not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index. led to recession every time. The University of Michigan consumer sentiment reading at 75.5 in December is lower than it was in March 2001 (91.5) and July 1990 (88.6) when the last two recessions began.

Furthermore, manufacturing is contracting, as evidenced by the recent Institute of Supply Management (ISM) manufacturing production index falling below 50. Exports are slowing, which is reflected in the ISM data and the 21% decline since November in the Baltic Dry Index. Overseas demand for U.S. goods was one of the bright spots driving GDP and earnings growth in 2007, and the persistence of this negative trend would remove a key driver for U.S. economic growth. Leading economic indicators have declined five of the last six months and will surely decline again in December. Increases in gas prices will rob consumers of approximately $40 billion in disposable income over the next 12 months unless prices decline.²

What could be different this time?
With this breadth of indicators, the probability of a recession continues to increase month after month. The good news is the duration and depth of the recession could be short and mild. Corporate payrolls are not bloated and inventories are lean, reducing the need for sharp cutbacks in spending. The strength in the global economy could surprise on the upside and buffer the U.S. economy from recession. Valuation measures would suggest much of the bad news is already in equity prices. The decline in share count from corporate buybacks, and the potential buying from both sovereign wealth funds and private equity firms could provide a supply/demand dynamic that would limit the market’s downside. Consumer sentiment is at levels that tend to generate powerful rallies, as measured by mutual fund selling and cross border money flows.³

For these reasons, I would be extremely surprised if the market decline approached 25%. Fed policy actions will continue to shape sentiment. Subprime woes were an obvious catalyst of sell offs last year, as a widening in the ABX spreads preceded every U.S. equity correction in 2007.⁴ Conversely, every equity rally was a result of anticipated or direct action by the FOMC. When the FOMC stepped up and allayed the fear of a recession by lowering the fed funds rate, equities rallied. When FOMC action was less transparent, equity markets corrected, as the perceived risk of recession increased. Market sentiment clearly changed for the negative in November when the market expected a 50 basis point cut in the fed funds rate, only to see the FOMC lower rates by 25 basis points. This negative momentum has carried into the new year as economic data continues to confirm the economy is slowing.

At 1418, the S&P 500 appears to be oversold. Another rate cut by the FOMC could set the stage for a powerful rally, considering the amount of money that appears to be on the sidelines. That said, investors should be concerned if the S&P 500 breaks below 1407, a level that held twice last year, and below 1370, the previous market low in March 2007. If the market breaks below 1370, I believe the next major support appears to be 1223, the low point in 2006.

Consensus earnings estimates for 2008 appear to be ridiculously high at $102.67, up 15.9%. As a comparison, Goldman Sachs expects 2008 S&P 500 earnings to decline 3.5%, to approximately $87.25.⁵ Richard Berner, Morgan Stanley’s chief economist, expects earnings to decline 2-5% if GDP grows between 1-2% and for earnings to decline as much as 5-15% if the economy grows 0-1%.⁶ The earnings outlook for the market falls squarely on the financial sector, which represents a 17% weighting in the S&P 500 but 31% of the S&P’s corporate profits. The problem for financials is that they still have assets on and off their books that are difficult to price. Questions remain on the degree of financial liability to the firms that sold investment vehicles packaged with subprime loans. Suitability issues have already surfaced in the news, with some firms setting aside monies to cover potential losses.

Invest for capital preservation
Investors should keep in mind that the past is never a guarantee of future results. Nevertheless, investors need to be cognizant of the potential downside if a recession ensues. Recessions have not been kind to equity markets in the past. Consider in previous recessions dating back to 1970:¹³

• The Fed tends to cut the funds rate an average of 400 basis points.

• Baa credit spreads tend to widen by more than 180 basis points. Currently they have moved about 100 basis points from the bottom.

• Commodity prices fall, with the CRB (Commodity Research Bureau) index tending to decline 16%.

• The U.S. dollar tends to fall 7% on a trade-weighted basis.

• Corporate operating profits decline 60%, and earnings tend to decline 15.7%.

• The peak to trough decline in the S&P 500 has averaged 25%, which could place the potential downside at 1173.

• Best performing sectors tend to be telecommunications, health care and utilities.

• The worst performing sectors tend to be financials and consumer discretionary.

• Small cap stocks under perform large caps by roughly 300 bps.⁷

The investment goal during this period of turbulence and uncertainty should be capital preservation, in my opinion. I would continue to overweight large cap growth companies, which tend to outperform for two years after a peak in corporate profit growth. Although large cap growth stocks outperformed in 2007 they are still trading 38% below large cap value, 46% below small cap value, and 60% below small cap growth on a total return basis since the October 2002 low¹⁴. Therefore, valuations still favor large cap growth stocks relative to mid and small cap stocks.

On the value side of the style allocation, I would front load returns by investing in companies with high dividends and those that have a history of increasing dividends. I would also consider investing in instruments utilizing option-writing programs. Traditional value investing may become difficult because the dispersion in stock valuations is narrow, except for the financial stocks. In other words, stocks aren’t cheap enough to gain an advantage over other investment themes. Alternative investments that allow the manager to trade long or short would seem appropriate in this period of uncertainty. However, alternative investments are not suitable for everyone.

On a thematic basis, I prefer investments that can benefit from the increase in global infrastructure spending and rising food costs. I continue to like the health care and telecom sectors. Consumer staples and utilities appear expensive now, but historically they perform well in this environment. Despite the sell off and cyclicality in the technology sector, I still favor certain sub-sectors in that space, particularly semiconductors at present prices. I believe the “tech cycle” has become somewhat disconnected from the U.S. economic cycle, and tech spending as a percentage of GDP will continue to grow, especially in the emerging markets.

There are also areas that merit trimming. Investors may want to consider reducing positions in small cap companies, companies with unpredictable income streams, cyclical stocks, and positions in the emerging markets ex-Asia, on market rallies.

Will the international equity markets delink from the U.S.?⁸
Rising downside risks to U.S. economic growth have dimmed enthusiasm for the international decoupling story. To be sure, I do believe that a number of international markets are less reliant on the U.S. for growth than they have been historically. However, a certain level of vulnerability, particularly in the emerging markets, remains.

Emerging Markets
Today emerging markets represent the largest economic bloc, accounting for 30% of the global economy versus 25% for the U.S. and 24% for Europe.⁹ China has become the largest contributor to global growth, and Russia, Brazil and India are among the top eight, according to the International Monetary Fund (IMF). Many of these countries are now operating with budget surpluses instead of deficits, mainly due to the commodity boom and globalization. Performance of emerging markets since January 2003 has been spectacular, up more than 400% on a total return basis.

At the macro level, emerging market performance in 2008 seems inevitably tied to the direction of commodity prices. If commodity prices decline, as they usually do in a recessionary environment, the asset class will likely struggle to generate positive returns. However, not all regions will be negatively affected. As a primary importer of raw goods, the Asian markets would tend to benefit from declines in commodity prices, which could increase profit margins. On the other hand, commodity export regions such as Latin America would tend to suffer from lower prices.

Regionally speaking, Asia’s fundamentals are “second to none,” in Morgan Stanley’s view, a sentiment with which I fully agree.¹⁰ Economic growth in the region is growing north of 7% in most countries. Exports are up 14.1% year-over-year. There is plenty of liquidity; foreign exchange (FX) reserves are at a record US$2.7 trillion. The banks loan-to-deposit ratio is a record low 72%. The quality of earnings and corporate balance sheets look great; corporate returns on equity (ROE) are at a near-record 15%, and net debt/equity is at a record low 34%. For these reasons alone, I favor the emerging economies in Asia over Latin America.

That said, however, emerging market equities in aggregate look vulnerable in 2008. Although the emerging markets are less dependent on exports to developing countries, they are not immune to an environment with less liquidity, continued problems in the global credit markets, a U.S. and European economic slowdown, and changes in local growth and inflation dynamics.

Technical factors also point to challenges ahead. Whenever the emerging market index has outperformed the developed markets by 30% in the previous year, they tend to underperform the following year.¹¹ Emerging market returns tend to be negative after the index trades more than 20% above its 200-day moving average, as it has recently. A tremendous increase in money flows into the region also tends to be negative for future returns.

Emerging market valuations are expensive. The emerging markets are trading at an 11% premium to the developed markets, with a trailing P/E of 17.7%. It has only traded at a 10% premium for five months in the past 15 years. Only in the 1993-1995 bull market, which has the greatest top-down similarities to today’s situation (including a weak U.S. dollar and housing slowdown) did the asset class ever trade more expensive in absolute terms than it does today, and then for only three months.¹²

Europe
Valuations remain compelling for the European market, looking at the spread between the earnings yield and bond yields. The European Central Bank (ECB) is likely to cut rates by 50 basis points this year in response to sharply slower GDP growth, a strong currency, and to ease credit concerns. The European equity markets also enjoy a low net issuance as corporate buybacks exceed stock issuance, providing a supply/demand dynamic that tends to drive equity prices higher.

Taking a cue from the U.S. market, the period following a peak in the profit share of GDP has been a favorable one for European large cap stocks. Investors should consider overweighting large cap growth companies with predictable income streams and companies benefiting from growth in the emerging markets. France is my country of choice because of the potential for further reforms, and health care is my favorite sector in Europe. However, investors should consider overweighting Europe with reservations. There are lingering issues that could dampen market returns including the region’s exposure to the subprime market, inflationary pressures that may limit ECB rate cuts and profit margin contraction that could negatively impact earnings. The best predictor of European earnings has been U.S. trailing 12-month earnings, which have turned negative.

Japan
The Japanese market is under owned and oversold, in my opinion. However, it currently appears to be a classic “value-trap” – in other words, Japan’s equity market is undervalued, but it lacks a catalyst that would move the equity market higher. It now seems likely the Japanese economy will fall back from the 2% growth rate trajectory of the past five years. Monetary policy is gridlocked and the interest rate hike scenario is fading fast. One of the problems with the Japanese economy has been a lack of domestic spending. Consumer confidence surveys continue to deteriorate, which doesn’t bode well for future spending. Moreover, a slowdown in other developed countries will hurt Japan’s economy, despite Japan’s recent economic expansion into China and other emerging economies. The risk of a strengthening yen, which would depress export earnings and likely drag the market lower, is another reason I would underweight this market.

Equity Allocation
The subprime problem ballooned into something greater than most strategists imagined or predicted. I’m not even sure the Fed was aware of the potential impact that the structured investment vehicle (SIVs) market could have across all financial markets. Tighter credit conditions is a very different environment than we dealt with last year, making this year’s investment outlook more difficult to predict because the financial sector is still in question. The rising probability of a U.S. recession should be strongly considered when making investment decisions; the risk is too great to ignore both domestically and abroad. Investors should seek capital preservation in the near term, focusing on large cap growth companies with more predictable earnings. If the duration of the recession is short and mild, better buying opportunities will present themselves later in the year.

Because most international markets are less dependent on U.S. growth today than their histories would suggest, I believe they offer a better risk/reward opportunity. However, emerging markets have had a great run and maybe things are different with this asset class considering their economic power, industrial base, and the improvement in fiscal and corporate governance. I believe this asset class would struggle in an environment with higher volatility, tighter credit conditions, and questionable growth in the developed markets. Investors will need to decide if it makes sense to take some profits off the table. Keep in mind, this asset class corrected 20% in August 2007 at the hint of a slowing U.S. economy. What kind of correction might occur if the U.S. economy actually falls into recession? I would overweight the developed markets over the emerging markets over the next couple of quarters.

As such, my allocations are as follows:
Stocks -
Bonds +
Cash ++

US	60%
Large Cap Value	34%
Large Cap Growth	50%
Small/Mid Cap Growth	10%
Small/Mid Cap Value	6%
Total Domestic:	100%
International	40%
EAFE	92.5%
Emerging Markets	7.5%
Total International:	100%
Total Equity Portfolio:	100%

This allocation is shown for illustrative purposes only. Investors should consider their time frame and all of their personal savings and investments, in addition to their assets and risk tolerance level. Your financial professional can help you assess your individual situation before you make any allocation decisions.

Note: If the S&P 500 breaks 1370, I would consider reducing the international allocation.

¹ The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The index does not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

² Calculation by Morgan Stanley, January 7, 2008

³ Analysis by Lehman Brothers, December 7, 2007

⁴ Analysis by Goldman Sachs, October 24, 2007. The ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages.

⁵ As of December 17, 2007

⁶ As of December 3, 2007

⁷ Statistics compiled by Merrill Lynch, January 7, 2008

⁸ Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.

⁹ Source: IMF, Morgan Stanley Research, October 25, 2007

¹⁰ Morgan Stanley Research, December 11, 2007

¹¹ Analysis by Lehman Brothers, October 22, 2007

¹² Statistics compiled by Morgan Stanley Research, November 2007

¹³ For a complete historical on the timing of the nation’s business cycles please consult www.nber.org and open the Cycle Dating Committee section.

¹⁴ Market Insights, 1st Qtr. J.P. Morgan, December 31, 2007

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.