Financial stocks often have been bellwethers for the economy and lately they've been flashing a warning signal. This sector is down 20 percent this year, thanks to mortgage losses and the US housing slump.
The bigger problem: More losses on bad loans lie ahead, but no one knows exactly how much.
Many investment analysts say banks will gradually find their footing – and in the meantime, investors can prosper in other stock sectors. But they concede that if the outlook worsens – if the economy enters a recession and bank woes impede the flow of credit, for example – the whole stock market could be in trouble.
"We as an economy have become more exposed to housing and financial services over time," says Jeffrey Kleintop, chief investment strategist at LPL Financial Services in Boston. "Financial services are dominant in the stock market."
This sector is now the largest within the S&P 500, whereas technology held the top spot in the late 1990s.
So far, the banking woes haven't put the broad market into reverse gear. The Standard & Poor's 500 index is up about 2 percent for the year.
In this delicate environment, Mr. Kleintop and other strategists offer a range of advice to investors, generally agreeing on these broad themes:
•If you still want to invest in financial stocks, check back in six months. Although financial or home-builder stocks may appear tantalizingly cheap now, remember technology stocks in 2000, Many investors were burned back then when they bought after dips, only to see those stocks plunge further.
•With the pace of profits slowing, the climate could favor growth companies, where earnings are still rising, over stodgier value stocks. In terms of sectors, this trend could favor technology, healthcare, and industrial firms that sell in global markets. "The classic growth sectors look very attractive," says Mr. Kleintop.
•Overseas, emerging markets could offer a particularly profitable, although volatile, ride. Emerging-market funds have been on an upward tear that could continue for several more years, some analysts say.
•Don't pull out of stocks entirely, but don't be 100 percent in them either, advisers say. And beware of committing too much money to one investment strategy, even if it seems like a sure thing.
•Cash has safety appeal. Having money on the sidelines could allow you to invest if better buying opportunities emerge. If you're not sure when to buy, you can buy in small steps over the course of the year.
Kleintop recommends that a typical investor keep about 55 percent of assets in US stocks, about 10 percent in overseas stocks, and about 35 percent in bonds or other fixed-income investments.
Investors can gain exposure to specific sectors through mutual funds or exchange-traded funds (ETFs), as well as by owning individual stocks. One ETF geared toward growth stocks is the Russell 1000 Growth Index (ticker symbol: IWF). Growth sector ETFs include Dow Jones US Technology (IYW), S&P Global Industrials (EXI), and Dow Jones US Healthcare (IYH).
But some analysts point to a potential pitfall of the growth strategy: Growth sectors could be among the hardest hit in an economic slump. (See chart, left.)
Technology is "one of the higher-risk sectors if a recession becomes imminent," says Jim Stack, president of InvesTech Research in Whitefish, Mont. Businesses can quickly pare back on high-tech purchases.
He recommends overweighting defensive stocks – sectors that perform relatively better than others in hard times.
For example, people still buy staples like food and toothpaste during recessions. One ETF that focuses on staples is S&P Global Consumer Staples Fund (KXI).
"Raise cash to a comfortable level," Mr. Stack tells investors, advising that 55 percent of assets now be in that safe harbor, and 45 percent in stocks.
"If I were going to make a mistake in this market, I would want to make it on the side of caution," he says.
Overseas, he sees the Japanese market as a good value.
Some advisers warn against certain traditionally defensive sectors, including electric utilities – since they've already had big run-ups.
But the bigger point is this: In a recession, all types of stocks tend to go down, some simply less than others.
"Losing less money than average is not my idea of fun," says Gary Shilling, an economist whose research firm is based in Springfield, N.J. His hot investment pick: Treasury bonds (see story, right).
Mr. Shilling frets that subprime home loans could be just the tip of an iceberg for banks that have lent freely in recent years to businesses and consumers alike.
As for all the talk about a recession, Ed Yardeni, a New York area economist, says that he worries about it. But "My forecast for 2008 is we will skirt a recession."
Mr. Yardeni sees the S&P 500 closing next year at a patriotic new high of 1776, about 300 points higher than its current level. He also recommends four sectors that have been on a roll thanks to strong global demand: industrials, technology, energy, and materials.
Joseph Quinlan, a strategist at Bank of America in New York, also recommends growth stocks, and particularly large companies.
Even though the European economy isn't racing ahead now, he says stocks there benefit from emerging-market demand for everything from cellphones to skyscrapers. "They've got a very robust backyard," he says.
Among emerging markets, Mr. Quinlan especially likes Singapore (MSCI Singapore Index: EWS) right now. Analysts at Merrill Lynch have put a "buy" rating on Brazil (MSCI Brazil Index: EWZ).
Meanwhile, analysts in the middle ground stress the need for investors to be carefully diversified.
"I don't think we're going to collapse or … be in a [market] free fall," says Alan Lancz, an investment adviser in Toledo, Ohio. But "we turned cautious on the market back in May…. It probably doesn't hurt to have a little cash."