What kind of year will 2008 be?  Brutal, unexpected, volatile, mostly down.

Why? Collision of 2 fundamental factors:

 * bad debt, mostly US real estate but also European real estate and all kinds of other debt including consumer, corporate, etc.  the debt binge was driven by collateralization, low standard, and expansive central bank policies, now comes the hangover.

 * real commodity shortages, mostly oil but also uranium, natural gas, corn, zinc, selenium... you name it, there isn't enough.  supply is fixed in the short term, and demand is very price-inelastic... result, after decades of insanely low prices and chronic underinvestment in production capacity, wild price spikes are likely.

What *would* be unexpected?  Consider international stocks (for example EFA/EEM) or the US broad market (S&P) on a 10yr logarithmic chart.  Since 2003, they are basically straight lines with a bit of noise.  In the real world, NOTHING goes up that fast or that predictably for very long... just around the time everyone is sure, I mean just positive, that it couldn't do anything but continue that basic trend, it jumps and does something very different.

In the case of the S&P, unexpected would be something like a drop to 800, or a jump up to 1700.  Given that the S&P is up 84%, or 13% per year annualized since 2003, you figure out which is more likely.  If we see a drop to below the major trend line, at 1350-1400 or so, watch out below.  Can't happen, you say?  Yep, and that is exactly why it will happen.  Markets are weird that way.

The financials index (XLF) provides a clue and an early warning indicator.  It is after all the sore spot, or where the real debt trouble has been brewing all along.  It was also in a more-or-less linear trend since 2003, closely matching the moves of the broad market index, until a major break under the trend line in June-July 2007 on heavy volume, just as the full extent of the real estate troubles was becoming known.  The 2-year XLF vs SPY chart is most illuminating in that regard.  If the financials are seriously broken - the price action seems to imply major writeoffs or even the dreaded b-word - do you think the economy as a whole can grow?  The bad debts have to be cleared out by, at best, dis-inflation of the assets that were previously inflated, such as real estate as represented in mortgage CDOs; or at worst, outright deflation.  The Fed will certainly do everything in their power to avoid deflation, so expect to get very choppy Fed-inflationary and debt-destruction-disinflationary cross-currents for a while.  And while that is happening, the real economy will take some collateral damage, with any big-ticket consumer spending or capital-intensive projects deferred due to the uncertainty and price instability.

Emerging or foreign markets will fall in sympathy.  Their *real* economies will not be much affected - South Korea for example has far more trade with Japan than with the USA - but the perception will be that they are affected.  Those markets have been due for a serious correction anyway, and a drop in US markets and/or high oil prices will provide the trigger.  After that happens would be a great time to buy, because growth in the developing/"new core"/BRIC world is one of the major trends of the century, never mind decade.

Speaking of oil: expect it to touch both $60 and $130 per barrel over the next year.  At a guess, it would spend more time in the upper end of that range, if not higher, but it will also be very volatile.  Extra supply is simply NOT available at any price in the short term, although there is no real shortage yet.  To curb demand, or at least slow demand growth, prices have to be ridiculously high by today's standards - at a guess gasoline in the USA may end up somewhere close to where gasoline has been traditionally in Europe, $5-$6 per gallon which corresponds to roughly $160 - $200/barrel oil.  How price-insensitive Chinese/Indian/rest-of-world demand is remains to be seen; but bear in mind that there is a very real possibility of a major production drop next year as well, most likely at due to a greater than expected drop at Mexico's Cantarell field.  Government hoarding is the wild card here.

The dollar is set to decline amidst all this, but governments are too heavily involved in managing the exchange rates (although not necessarily in the same direction) that the decline will be "contained".  Nobody wants any sharp moves; expect the dollar to drift to the low 60's by the end of the year, with occasional sharp moves up to shake off the currency speculators.  The drop from 85 to 75 over the last year has not had any visible effect on the trade deficit, leading one to wonder where the equilibrium rate might be.  Alas, there are virtually no pure US exporter plays... at best, there are some companies which would be exchange-rate neutral since they have roughly 50% revenue from exports share and 50% domestic cost component, like ITW.

Price targets by end of 2008:

S&P500: below 1200, possibly 1000 or less
financials: XLF below 20
oil: above 120, possibly 160
dollar index: low 60's
interest rates: low, but with much, much wider risk premiums - look for AAA/BBB spread over 3-4% and lots of decent junks with over 10% yields
stocks way up: SU, DNN, SSL
stocks way down: IMB, RDN, FRE