Jump Aboard the Distressed-Debt Bandwagon
1.

Sell Big Gainers Before Taxes Rise
What: Long-held equity, real estate, art and other assets that might have jumped manyfold in value over the price you paid.

Why: You might pay higher capital gains taxes after 2008.

How: Consider selling some of your highly appreciated assets this year to reap maximum cash.

The 15 percent tax rate on long-term capital gains, the lowest rate in the country’s history, is a temporary gift from the 2003 Jobs and Growth Tax Relief Reconciliation Act (extended by President Bush’s Tax Increase Prevention and Reconciliation Act of 2005). It will expire in 2010 unless Congress votes to renew it. If you are betting on renewal, you might also consider buying a nice bridge that leads to Brooklyn. In fact, Congress has the ability to raise the rate before 2010.

The economy and tax fairness will be major issues in this year’s election. In the next administration, no matter who is elected and no matter which party controls Congress, the capital gains tax is likely to rise, at least back to 20 percent. If you have entertained thoughts of selling certain assets that have seen significant gains, you are likely to come out ahead if you sell them in 2008. The gains in 2009 or 2010 might not be sizable enough to offset a tax increase.

"We’re getting a more restrictive environment, and we have all these other factors around trade policy and potential market volatility," explains Christopher Wolfe, chief investment officer for the Private Banking and Investment Group at Merrill Lynch in New York. "So it’s hard to see how the investment will appreciate by 10, 20, 30 percent. The odds are against it anyway. Taxes are probably not going to be your prime consideration in deciding whether to sell, but put it this way: Ignore at your peril the penalty you might pay if capital gains rates jump around as they have for much of the 50 years that they have been in existence. They have been as high as 90 percent, as low as 15 percent, up to 28 percent, then 35 percent, then back down to 15 percent."

Look for Deals in Emerging Markets
3. What: Undervalued companies based in emerging markets.

Why: The BRIC countries and many other developing economies have grown rapidly but are likely to see a slowdown this year, especially if the United States has a recession. Furthermore, as an asset class, emerging markets look overheated.

How: Invest through American depository receipts, foreign stock markets or funds specializing in niche sectors.

Ask almost any global investors and they will tell you that emerg-ing markets are overheated, especially China, where the Shanghai stock
market alone gained 110 percent in the first nine months of 2007. Merrill Lynch’s Erdman, for one, is reducing his clients’ weighting in China and India, albeit only for the short term. "We have used that sector as an alpha generator, at times moving 5 to 7 percent of an international weighting there," he says. "But now we’re directing the money to high-quality European companies in restructuring areas, and some to Brazil and a couple of other emerging markets. We want to be in China for the next 10 years, but we’re taking chips off the table now because we think that there is so much euphoria that there is a lot more risk than a year ago." A recession in the U.S. would likely hurt the emerging markets, which still depend heavily on exports in spite of their gradual "decoupling," as it is known on Wall Street, from the U.S. economy.

Hugh Simon, the CEO of Hamon Investment Group, a firm based in Hong Kong that specializes in Asian investments, is shunning stocks in the Chinese manufacturing sector. But when you are on the ground there, he says, you see a number of sectors with plenty of room to grow in tandem with a rise in domestic consumption and a major overhaul of the country’s infrastructure. Convincing Chinese households to spend some of the $2.2 trillion they have amassed in savings is problematic, but Simon is betting on growth in China’s own consumer-product companies, with brands that are becoming popular in the domestic market.

The retail loan market also looks rosy. Personal loans and mortgages from Shanghai’s banks rose in the third quarter of 2007 to nearly double the number of the entire first half, according to statistics from China’s central bank. Wait another two decades or so to ask about Chinese subprime; for now, Simon sees promise in bank consolidations and financial-sector growth as more people purchase homes.

"The retail brokerage companies will grow very rapidly into something more like investment banks, especially as the capital markets grow in China," Simon explains. "As more people buy houses and cars, they will need insurance, and there will be attractive opportunities in insurance companies." His firm sees potential value in companies in India that are under the $1 billion market-cap range, as well as in some of the IPOs coming up in Vietnam.

Large-Caps: Take a "Flight to Quality"
4. What: Multinational large-cap companies.

Why: The best of the major corporations have globally diversified revenue streams and enough cash to see them through a downturn.

How: Take long positions in stocks of recession-proof companies and short positions in more troubled ones.

"We don’t think global large-caps are particularly expensive right now," says Aaron Gurwitz, a managing director and cohead of wealth and portfolio strategy at Lehman Brothers in New York. In spite of European stocks costing U.S. investors a premium because of the weak dollar, he has faith in large-caps with large amounts of cash on their balance sheets and significant enough international holdings that they are not dependent on dollar-denominated revenues; that will help them weather a downturn. He advises clients to put about 35 percent of their portfolio into investments that are not denominated by the dollar.

In an uncertain economy, everyone heads for old-fashioned, dividend-paying blue chips, a phenomenon also known as "flight to quality." But when you are taking long positions in large-caps this year, think in terms of the more recession-proof industries. Consumer staples traditionally do well following a federal interest rate cut, and those with strong market shares in Brazil, Russia, India and China—commonly called the BRIC countries—and other emerging markets should benefit from the continued rapid growth abroad.

In the risky world of alternative energy, a number of investors are turning to the large-cap companies that are staking some of their own fortunes on R&D or acquisitions in this sector. Meloni Hallock, the CEO of Acacia Wealth Advisors in Los Angeles, likes the alternative-energy sector in general, with the caveat that a company needs a lot of capital to be a promising investment play. "There are a lot of entrepreneurial companies out there with great ideas, but if they don’t have the capital to stay in the game, they won’t make it," she says. Look instead for the energy and utility giants that acquire the best of the startups, she says. "It’s likely the big-time winners are going to be the large-cap companies, though as with the pharmaceutical industry, if one out of 50 projects is a big success, they’ll be ahead."

Although a number of analysts are now saying that the financial services industry has taken all of the write-downs necessary and is on its way to recovery from the subprime crisis, Ryan Atkinson, the chief market analyst at the hedge fund Balestra Capital in New York, says the idea that the troubled industry leaders are poised to outperform is utterly naïve. Balestra’s analysts forecast the housing market meltdown early in 2007, and the fund made most of its money for the year through shorting subprime debt obligations and mortgage-backed securities. Now Atkinson believes it might pay off to take short positions in some of the beleaguered financial services large-caps.

"The problem I have with this theory that they’re about to recover is that with many of the securities that they have written down, they probably have no idea what the real value is," Atkinson explains. He also points out that a short-term rally does not mean that all is well.

Ride the Commodity Wave
5. What: Gold and other precious metals, water, and agricultural commodities.

Why: Commodities are denominated in dollars, so values rise when the dollar is weak, and global demand is likely to grow in the years ahead.

How: Invest through specialty indexes or funds.

Those goldbugs who believe the dollar is headed toward a collapse never explain how many loaves of bread you will be able to buy with an ounce of gold when the end of the world hits. Balestra’s Ryan Atkinson does not look or sound like one of them. But having accurately foreseen the property meltdown, he now says gold can climb much higher in the next couple of years. "It’s likely to be a market much like the 1970s, where it explodes; and we are just halfway through it," he says. "By the end of 2008, gold could go up to $1,000, and it could get higher over the next three to five years."

Gold is likely to climb not because the U.S. economy is headed for complete collapse, Atkinson says—though he does predict a mild recession spinning off from the housing and consumer-debt crises—but because of the extraordinary amount of liquidity sitting in central banks abroad. "You can look at gold as an antidollar play but also as an antifiat currency play," he says. "The dollar is structurally weak. It might be oversold short-term, which will lead to a sharp rally, but if foreign nations come in and support the dollar, they will be creating more liquidity. This is also bullish for gold. So instead of gold rising just in dollar terms, you will see gold rising in terms of all currencies. Plus, we think a considerable portion of the reserves sitting in central banks, particularly Asian central banks, will wind up in gold."

Lehman Brothers’ Gurwitz advises moderately risk-averse investors to put about 4 percent of their portfolio into commodities. "In a sense, this is currency exposure," he says, "because the investment is in dollars. The price of oil will stay the same for everyone in dollars, but when the dollar depreciates, the price of oil goes up."

Oil has been trading at an all-time high, and base metals have been in a bull-market run since 2001. More-basic commodities, such as food and water, may go higher. Rob Giannetti, a private wealth advisor and portfolio analyst at Merrill Lynch in New York, likes the PowerShares water index, which includes domestic and foreign water companies. Agricultural commodities benefit from global inflation. Also, despite problems in developing ethanol, the biofuels industry is still growing, and is expected to increase global demand for other crops, including wheat and sugar. "In late 2008 and into the next few years, agricultural commodities should be a leader," says Atkinson.

Illustrations by David Johnson.

Jan Alexander is a features editor for Worth.