Iffy 2008 outlook for Wall Street

After enjoying years of rising profits, American businesses face the prospect of tougher times in 2008.

An outright decline in earnings is possible, although that isn't the mainstream Wall Street forecast.

If profits were to fall, that would ripple beyond corporate boardrooms in two important ways. Companies would become reluctant to create new jobs because profits provide fuel for corporate investment. And US stock markets would struggle to make gains, clouding the ledgers of many households even as their other main source of wealth – homes – are falling in value.

Already in 2007, profits from US business activity have been falling. Their overseas operations have become the main source of momentum.

"The domestic part of the economy is very close to recession," says Michael Cosgrove, who publishes The EconoClast, a market newsletter in Dallas. "The best situation is probably flat profits for 2008," or perhaps a modest rise, he says.

In general, the direction of stock prices depends heavily on corporate earnings. But other factors also come into play, and one of the most important for 2008 promises to be politics.

"The uncertainties generated by the election are extremely high," Mr. Cosgrove says. As the presidential campaign season progresses, investors may get a clearer sense of the likelihood of new policies on everything from taxes to trade to healthcare.

All the doubts – about elections, the economy, and profits – don't necessarily mean a bad year for stocks.

The prevailing view on Wall Street is that profits will be better in 2008, after a year when home-loan troubles weighed heavily on the share prices of financial firms. Analysts expect 16 percent earnings growth in 2008 for the Standard & Poor's 500 companies, well above the 1 percent gain they expect to see in 2007 once the final quarter's reports flow in.

Could they be right?

Often, election years are good for stocks, perhaps because incumbent politicians try to coax the economy forward in those years as best they can.

What's clearest is that the profit picture will depend on where the economy heads. Consider what's happened to profits in recent years, as recorded by the US Commerce Department's Bureau of Economic Analysis: When the economy slowed into a recession in 2000, profits took a dive. Then they soared as the economy recovered. Lately, the annual gains have come at a slower pace, hand-in-hand with a softening in the rate of economic growth.

Now, amid concerns that a recession is possible, analysts have been paring back their expectations for corporate earnings.

"The growth rate [forecast] has pretty much been dropping steadily" in recent weeks, says John Butters of Thomson Financial, which tracks earnings estimates of S&P 500 companies.

The pattern shows up clearly in forecasts for the quarter that ends Monday.

Back in October, analysts predicted that profits would be 12 percent higher in the fourth quarter than they were in that same period the year before. Now, says Mr. Butters, they're predicting that fourth-quarter profits will fall 9 percent over 2006's fourth-quarter earnings.

This backdrop appears likely to affect businesses' ability to create jobs and spend money on new facilities in 2008. Surveys of corporate executives, released earlier this month, show rising pessimism. In the latest monthly survey by CEO Magazine, only 16 percent of chief executive officers say they expect hiring to increase in the next quarter, while 41 percent expect a drop.

A separate survey of chief financial officers, by Duke University and CFO Magazine, found CFO optimism lower than during the 2001 recession.

If profits shift into reverse gear, it could also mean declines in share prices for investors, including those with pension and retirement accounts.

Such a reversal is possible, because of the slowing economy.

"Be prepared for a tsunami of earnings downgrades in 2008," economists at the investment firm Merrill Lynch warned in a recent report to clients. By their analysis of the overall business climate, profits appear poised to fall 7 percent in 2008.

Joseph Quinlan, chief market strategist at Bank of America in New York, says troubles in the domestic economy could overwhelm the gains from operations overseas – which in 2007 were enough to offset domestic losses. The problems include a housing slump and a related squeeze in banking and credit.

"It's a workout process," Mr. Quinlan says. "It's going to take some time."

Some analysts say investors should be ready to see a bear market in stocks – perhaps early in the new year – followed by a recovery later in the year if the economy appears set to pick up.

Others, though, say share prices could rise despite a cooling economy. For one thing, current stock prices already reflect some expectation of bad news.

Abby Joseph Cohen, market strategist at Goldman Sachs, recently forecast that the S&P 500 index will end next year at 1675, well above its Friday close of 1478. A key reason behind the investment firm's call: Stocks are already priced for a cooling economy and could rise if things simply go OK. Ms. Cohen predicts 1.8 percent growth in the economy next year, profits rising by 5.6 percent, and inflation of consumer prices at a relatively tame 3.5 percent.

"There are indeed some very ugly scenarios lurking in the background that cannot be dismissed out of hand," she writes with other Goldman strategists. But they predict that "US stocks will offer moderate gains."