The “R” word pops up often when talk turns to U.S. economic prospects for 2008. And even though economists are split on whether a recession will actually take place, it’s making U.S. investment planning for this year problematic, to say the least.

Some economists, such as investment strategist Gary Shilling in Springfield, N.J., believe the U.S. economy is already in recession; others, including Alan Greenspan, the former head of the U.S. Federal Reserve Board, say the odds are 50/50 that a recession will happen this year; a fair number of others think the U.S. will sneak through 2008 without one.

And despite all this talk of recession, investment analysts are generally bullish, adding to the confusion. Standard & Poor’s Corp. analysts, for example, believe operating earnings for the S&P 500 composite index will rise by 16%. However, their estimate is a bottom-up affair, looking at prospects on a company-by-company basis. It is from broad, top-down economic analysis that the gloomy forecasts come.

For Canadian investors, there is a second and equally large challenge: figuring out how the Canadian dollar will perform against its U.S. counterpart. Canadian investors were big losers in 2007, when the loonie closed as high as US$1.08 on Nov. 6, 2007, up from US84¢.

Canadians who invest in U.S. stocks win when the loonie drops, but lose when it rises. If your client were to buy a U.S. stock at, say, US$14 a share when the loonie was at US90¢, it would have cost him or her $15.56. But assuming your client then sold that stock, still trading at US$14 a share, when the loonie had risen to US$1.05, he or she would have received $13.33 a share — for a loss of 14%.

Since economists are divided on whether the C$ will go up or down, this adds to the risk of investing in the U.S. market.

Furthermore, if the loonie fluctuates around parity with the greenback, as it did late in 2007, timing becomes a problem. In that case, your client ideally would buy U.S. securities when the loonie is strong and sell them when it is weak. But that’s tricky.

A plunging US$ is a worldwide economic risk. Last year’s global credit crisis started with the realization that U.S. subprime mortgage debt was, in fact, a trashy investment. Foreign investors for years have poured their excess cash into U.S. debt, which now looks like a bad idea. Those investors have been selling some of their holdings, and that has pushed down the value of the greenback against just about every other currency.

It is American consumers who will determine whether there is a recession. Their spending accounts for 70% of U.S. gross domestic product. In the past few years, they have viewed home ownership as a source of income, thanks to loose lending practices and the belief that house prices could never drop. But now that house prices are dropping and mortgage defaults are rising strongly month by month, the consumer mood is changing.

This puts consumer-related stocks at risk, although analysts still expect gains in this sector in 2008. However, they prefer industries that may be less affected by a business slowdown, such as health care, technology, utilities and telecommunications services.

Investors should also consider two more factors: capitalization and dividends.

In terms of capitalization, leadership in the U.S. stock market is changing. Although small-cap stocks outperformed the market between 2000 and 2006, they have fallen further and further behind the rest of the market since early 2007. In relative terms, large-cap stocks are coming on strongly.

So, a switch to large-cap stocks makes sense if the U.S. economy stumbles or falls because large companies have greater resources with which to withstand economic hard times. In recessions, they outperform small-company stocks.

Large-cap stocks will also help offset the impact of the dropping US$. These companies are largely multinational. Foreign sales account for about 45% of total sales for companies in the S&P 500 composite index, the favoured benchmark for market performance. Entering 2008, that proportion could already be as much as 50%, according to S&P.

A focus on dividend-paying companies also makes sense in periods of slow growth or recession. Says Charles Allmon, editor of Maryland-based advisory service Growth Stock Outlook: “In the rough and tumble stock market that I anticipate over the next couple of years, cash dividends — and especially rising dividend payouts — may serve us well as a market prop. Historically, companies without hefty dividend payouts plunge like comets in severe market shake-outs; and they do not bounce back quickly.”

@page_break@This trend is already evident. Dividend-paying stocks in the S&P 500 gained 3.4% in the 12 months ended Nov. 30, while non-dividend-payers gained 1.8%. In November alone, dividend-payers fell 4.4%, while non-payers dropped 7.5%.

Here is a sector-by-sector look at prospects in the U.S. market for 2008:

> Health Care. This sector is favoured because of its presumed recession-resistant character. However, analysts don’t like the major pharmaceutical stocks because many of these companies stand to lose patent protection on major drugs in the next few years. One such example is the cholesterol-lowering drug Lipitor, which is produced by Pfizer Inc. In addition, these companies’ research efforts have developed relatively few promising compounds. Other parts of the sector, such as managed health care and medical products, have steadier growth prospects.

Although the sector’s anticipated 14% profit gain for the year is lower than that for some other sectors, it is one part of the economy in which employment is growing.

UnitedHealth Group Inc., a managed health-care firm, has a four out of five stars investment rating from S&P and earns S&P’s highest quality rating for earnings and dividend growth. Allergan Inc. makes headlines with its Botox product, but its sales of glaucoma and dry-eye drugs and medical devices rate highly with analysts.

> Utilities. Firms in the utilities sector have seen strong growth, but analysts see additional gains. Companies with good dividend records and growth possibilities are favoured.

S&P gives natural gas distributor Nicor Inc., with its yield of more than 4%, a top rating for this sector, which is dominated by electric utilities.

Electric utilities companies carry high valuations, but this has not prevented several firms from going private by way of acquisition. On a technical basis, it is perhaps significant that eight utilities in the S&P 500 are expected to have big gains: Allegheny Energy Inc., CMS Energy Corp., Consolidated Edison Inc., Dominion Resources Inc., PPL Corp., Progress Energy Inc., Questar Corp. and Sempra Energy.

Water utilities companies have long-term interest. Among the large companies in this industry are Aqua America Inc., California Water Service Group, SJW Corp. and American States Water Co.

> Telecommunications Services. Telecom companies have the largest forecast increase in earnings, at 33%, even though analysts have some concerns about their need to borrow for continued capital spending. Their record as defensive stocks enhances their appeal. Dividends in this sector are rising.

Citizens Communications Co. is analysts’ prime choice for 2008. Insiders are buying shares and the company has expected cost savings from recent acquisitions. Embarq Corp., a recent spinoff from Sprint Nextel Corp., offers the prospect of dividend increases.

> Information Technology. Now the second-largest industry sector, IT also has big profit growth expectations. Favoured stocks include computer hardware and software producers, such as Hewlett-Packard Corp. (hardware); Compuware Corp. and Intuit Inc. (software); EMC Corp. and Logitech International SA (computer storage and peripherals); and Cognizant Tech Solutions Corp. (consulting).

VMware Inc. is also favoured because of its leading position in “virtualization” software. Two familiar names — Microsoft Corp. and Oracle Corp. — stand out in the systems software market.

> Energy. Performance for U.S. energy companies in 2008 depends on world oil prices and North America natural gas prices.

As the single most important commodity, oil will determine whether the commodity bull market will endure. Should the price of oil jump above its US$80- to US$100-a-barrel trading range, the risk of recession multiplies. But, barring a major terrorist attack, that trading range is likely to persist.

The giant international integrated oil companies offer geographical diversification. For example, 70% of Exxon Mobil Corp.’s sales are outside the U.S.

Emerging renewable-energy industries, such as solar, geothermal and wind-powered energy, are gaining strength. Florida-based FPL Group Inc., for instance, plans to spend $2.4 billion on solar-energy production and wind-power generation.

> Industrials. The market’s fifth-largest sector, industrials are dominated by aerospace and defence companies. The long-term business outlook for both subsectors is positive, although growth in commercial aircraft orders will slow. Goodrich Corp. and Triumph Group Inc. have high ratings in this area.

In industrial machinery, Danaher Corp., Harsco Corp. and Lincoln Electric Holdings Inc. are highly rated. Cooper Industries Ltd. is the leading choice in electrical components and equipment.

The sector includes transportation stocks, which are already feeling the effect of slowing economic activity.

> Materials. This sector has a different conformation in the U.S. stock market than it does in Canada. In the U.S., chemicals, fertilizers and industrial gases are the major components rather than industrial metals and gold. During 2007, the U.S. sector index was as much as 33% higher than a year earlier. Momentum has slipped, though, because profit growth is expected to be slow in 2008.

> Financials. This sector accounted for 22% of the S&P 500’s market cap at the beginning of 2007. By yearend, however, that had dropped to 18%. Financial services stocks started to underperform in May. As the credit crisis deepened and more and more financial institutions confessed to having huge losses in subprime mortgage debt, valuations dropped heavily.

Given the possibility of additional loan losses, the risk of buying into this sector looks too high.

Insurance companies may be least affected by the crisis, but their stock-market appeal is likely to be tainted by association.

> Consumer Discretionary. These stocks are already dropping despite the large profit increase forecast by analysts for 2008. Relative to the overall market, the sector peaked early in 2005.

If the U.S. does go into recession, this sector will be hit, with automakers and retailers likely to take the brunt. One group that does have appeal, though, is restaurants. Among them, McDonald’s Corp. has high expectations for 2008.

> Consumer Staples. These companies should hold steady because their products are everyday necessities. Household products, packaged foods, soft drinks and tobacco are the largest industries.

Procter & Gamble Co., the prototype consumer-goods company, carries S&P’s highest quality rating and its market performance suggests further strong gains. It also offers international diversification because 54% of its sales are outside North America.

Market action also suggests potentially large gains for Avon Products Inc., Campbell Soup Co., Kellogg Co., Reynolds American Inc., UST Inc. and William Wrigley Jr. Co. IE