In 2007, investors got to experience two very different stock markets for the price of one. The first market, buoyed by easy credit and...

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In 2007, investors got to experience two very different stock markets for the price of one.

The first market, buoyed by easy credit and heavy buyout activity, lasted until late July. Investors may have worried about the weakening housing market, but as equity strategist Jack Caffrey of JPMorgan Private Bank put it: “The assumption was that if things got rough, you could get bailed out by the Fed or a private-equity firm.”

The second market was whipsawed by the collapse of mortgage lending, the subsequent credit crunch and growing recession fears — in Caffrey’s words, “the rediscovery of risk.”

That was the market in evidence Monday, as stocks closed out 2007 on a down note. The Dow Jones industrial average dropped 101.05 points to finish at 13,264.82. The broader Standard & Poor’s 500 index fell 10.13 points to close at 1,468.36, while the technology-heavy Nasdaq composite index was down 22.18 points, ending at 2,652.28.

All the major indexes declined in the fourth quarter. The Dow, for instance, was off 3.2 percent, its worst fourth-quarter performance in two decades.

Yet the markets did post modest gains in 2007, thanks to the big run-ups earlier in the year. The S&P, for example, hit an all-time high of 1,565.15 on Oct. 9, representing a 10.4 percent gain since the start of the year.

But the drumbeat of bad news about slumping home sales, unmarketable mortgage loans and slowing consumer spending took its toll. By the end of 2007, the S&P could only claim a modest 3.5 percent gain for the full year.

The Dow and the Nasdaq did better, posting full-year gains of 6.4 percent and 9.8 percent, respectively.

Analysts noted that the further you were from the tainted mortgage sector, the better the markets looked.

Jack Ablin, chief investment officer at Harris Private Bank, said technology stocks and other growth companies have largely ridden out the credit crunch. Such companies typically carry little debt and fund most of their growth internally, he said.

“The entire lending industry could freeze up and these guys could operate pretty much as usual,” Ablin said.

Indeed, most of the leading Northwest stocks in 2007 were in the tech sector: Bellevue-based software maker Bsquare (up 138.2 percent), Seattle online retailer (up 134.8 percent), Redmond software maker Concur Technologies (up 125.7 percent).

Another Redmond software maker you might have heard of, Microsoft, had its best year since 2001, closing at $35.60, up 19.2 percent.

Given widespread expectations that the U.S. economy will slow dramatically this year, if not fall into recession, defensive stocks — those not closely tied to the ups and downs of the economic cycle — performed well in the fourth quarter. Those included energy firms, health-care providers and companies that produce or sell consumer staples, such as groceries and household products.

But businesses that depend more on consumers’ discretionary dollars were among the year’s poorest performers: automakers, appliance manufacturers, department stores and specialty retailers.

Women’s-clothing retailer Coldwater Creek, headquartered in Sandpoint, Idaho, fell 38.4 percent in the fourth quarter and was down 72.7 percent on the year.

Investors bet the housing slump — and the prospect of interest rates resetting higher this year on millions of adjustable-rate mortgages — will cut into consumer spending, said Steve Rhone, CEO of investment-management firm Wentworth, Hauser and Violich.

“If the value of my real estate is down 10 or 12 percent year over year, I’m probably not going to feel as confident about going out to buy a car or furniture,” said Rhone, whose firm has offices in Seattle and San Francisco.

Mortgage lenders, not surprisingly, bore the brunt of the downturn; the sector was off 39.3 percent in the fourth quarter alone and finished the year down 50.3 percent.

But even at other financial institutions, exposure — or feared exposure — to dubious mortgage-backed securities dragged down their shares.

Seattle’s own Washington Mutual, one of the nation’s largest home lenders, lost more than three-fifths of its market value in the fourth quarter, as its share price sank from $45.49 to $13.61.

The declines in the financial sector haven’t been as steep lately — reflecting, Rhone said, a sense among investors that the bottom of the mortgage mess may be within sight.

“They’re starting to get a little more confidence that the worst of it is behind, and that’s taken some pressure off the market,” he said.

Given the precarious state of the U.S. economy, companies with exposure to the rest of the world — which tend to be the larger, more diversified ones — outperformed the broad market in 2007.

The Russell 1000 index of larger companies, for instance, rose 3.9 percent, while the Russell 2000 index of small companies was down 2.8 percent.

Many market watchers expect 2008 to follow a pattern similar to the tail end of 2007: lots of volatility, with large-caps, growth stocks and defensive issues in the lead.

“It continues to be our belief that we avoid a recession,” Caffrey said.

“But with the economy becoming less certain, we think investors will pay more attention to sustainability of earnings.”

Drew DeSilver: 206-464-3145 or