2007 Market in Review: Burning Down the House

Understanding the performance of the stock market in 2007 comes down to one word: subprime.

No other concept so dominated Wall Street -- not by a long shot. The subprime mortgage collapse, in which hundreds of thousands of Americans lost their homes after signing on to

A home is advertised for sale at a foreclosure auction in Pasadena, California.
Reed Saxon
A home is advertised for sale at a foreclosure auction in Pasadena, California.

adjustable-rate mortgages with low teaser rates, permeated through the markets.

The nation's top investment banks are expecting to take $100 billion or more in write-downs because of subprime losses, while consumers hamstrung by resetting ARMs were delinquent in credit cards and spent less money at retail outlets.

That the major indexes managed to make it through the year with modest gains was testament to the resiliency of the U.S. economy. The Dow rose about 6.6 percent in 2007, the Nasdaq 8.9 percent, and the S&P 500 3.7 percent.

But analysts worry about what could loom ahead in 2008 as the subprime crisis's effects continue. The real estate market has continued to languish, and there areworries about whether the market would be overwhelmed by excess inventory as banks tighten lending standards.

"The beginning of the new year does not change the problems," said Quincy Krosby, chief investment strategist at The Hartford. "What will help is new management coming in and just doing what's necessary to get balance sheets shored up. That's what the market is waiting for, and at some point we're going to see that."

Indeed, some of those investment banks had major shakeups at the top directly related to the subprime crisis this year.

Fallout at Merrill, Citi

In October, Merrill Lynch CEO Stan O'Neal stepped down, just days after the bank reported its first-ever quarterly loss.

Shortly after O'Neill's departure, Citigroup CEO Charles Prince announced he too was retiring as that firm struggled to cope with the billions in losses it would sustain from the subprime collapse, which crippled the financial sector even though the risky loans make up only 12 to 15 percent of all mortgages.

"What was interesting for me was how the subprime problem ... metastasized globally and infected the entire global financial market, how it morphed into something which knew no global boundaries and knew no size of the institutions that it was going to affect," Krosby said. "That's the surprise, that we didn't realize the amount of leverage this would have."

The ripple through the financials was palpable, with a number of key names taking a beating, including Citi , 2007's biggest loser for the Dow (down 47 percent on the year); as well as Countrywide Financial (down 79 percent), MBIA (down 74 percent), and Ambac Financial Group (down 72 percent), all of which were in the top five of S&P 500 laggards.

Financials led the S&P decliners, with the sector down about 21 percent in 2007.

Amid the subprime fallout and the market's extreme volatility -- the CBOE Volatility Index gained nearly 20 percent -- came an increasing clamor for more action from the Federal Reserve.

A series of Fed rate cuts still left investors dissatisfied. The central bank also capped off its activity in December with bond auctions aimed at getting money into the marketplace, but investors generally shrugged off the move, and analysts criticized the Fed and its chairman, Ben Bernanke, for indecision in the wake of the credit crunch.

It has all added up to uneasy feelings as to whether the U.S. economy is heading into a recession, and investors are still looking for the Fed to do its part to stave one off.

"The economy is almost a textbook example of an inflection point as to whether or not we go into a recession," Krosby said. "We're in the camp right now that it's probably 47 (percent in favor of a recession) and 53 (percent against).

"We're paying very close attention to employment data and all the surveys of what CFOs and CEOs are thinking, and more importantly what they're doing. The consumer can hold on as long as we have rate cuts and as long as we have employment intact."

Oil: A Wellspring for Markets

Of course, 2007 wasn't all doom and gloom, and the year had its winners.

While most market-watchers cite subprime as the main business story of the year, oil ran a close second as the price per barrel for U.S. light, sweet crude gained 57 percent for the year -- never quite eclipsing the $100 threshold but coming close on several occasions, with a high of $99.29 on Nov. 21.

Consequently, energy stocks paced the S&P in 2007, gaining 34 percent, with ExxonMobil leading the way among bluechips and National Oil Well Varco the biggest gainer overall in the sector, as the company's shares rose 143 percent for the year, the most of any S&P stock.

Energy companies in particular have been adept at capitalizing on the popularity of exchange-traded funds.

"I think oil is more right now about speculation," said Nadav Baum, managing director of investments for Pittsburgh-based BPU Investment Management. "This ETF world has brought a whole new game to town. The retail investors had a hard time buying these types of equities and these types of baskets of stocks until this whole ETF thing exploded."

Baum is advising his clients toward investment in both energy and financials, which he said have neared a bottom and will begin a slow turnaround.

"Financials will be pretty good," he said. "There's going to be some select ones that get hammered, but the reality is they're good companies and they've already gotten beaten up."

Generally speaking, Krosby believes large-cap stocks again will be in favor in 2008. 2007 was a dismal year for small-caps, with the Russell 2000 index down more than 2 percent.

Retail Blues

Retail also had a difficult year, with holiday shopping showing less of a year-over-year increase than many investors had hoped for.

Among the biggest losers of the year was Home Depot, which tumbled more than 33 percent in 2007 as sales of construction materials slowed along with the real estate market.

The consumer discretionary spending sector fell 14 percent, the second-biggest loser among S&P sectors. Circuit City stock took a pounding, as did American Express, the fifth-worst performer among Dow components.

Conversely, materials (up 21 percent), along with technology and utilities (both up 14 percent)all saw solid years.

Apple, boosted by the release of its much-anticipated iPhone, gained a stunning 135 percent on the year, while chipmaker Intel was the fourth-biggest gainer on the Dow, rising 32 percent.