Fat Dow? Will Stocks Gain More Weight in 2007?
by: Nick Raich

As 2006 draws to an end, Wall Street investment strategists are beginning to place predictions on the 2007 closing prices for the Dow Jones Industrial Average and the S&P 500. The National City Private Client Group also forecasts market returns. Our expectation is for high single-digit to low double-digit stock market returns in 2007.

Favorable Weather Conditions
Coincidentally, this was the same forecast we made last year for 2006. Before we begin to explain the rationale behind our prediction, we think it is important for investors to remember one key element about our forecast—or anyone else’s for that matter. Stock market forecasts are similar to weather forecasts. A weatherman makes his forecast based on current and projected atmospheric conditions. Despite improved technologies, a weatherman cannot determine exactly when or where, or even if, lightning may strike. Determining the precise value of the Dow or the S&P 500 on the last day of trading in 2007 is like trying to predict when lightning will strike; it is virtually impossible. What is not impossible is helping you decipher the bullish and bearish factors that loom on the horizon and whether economic conditions are favorable or unfavorable for owning stocks.

Stocks have not kept pace with the rise in corporate earnings
What has gotten us to this point? Let’s take a look. Stocks should post their fourth consecutive year of gains in 2006. As a matter of fact, from the beginning of 2003 through the end of October 2006, the S&P 500 index has returned 67.8 percent. It should be no surprise why the market has done so well over that time frame. Productivity gains and the effects of globalization have allowed corporate earnings to sustain double-digit growth every quarter since late 2002. This earnings growth has been remarkable and unprecedented in its length.


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Some investors, still remembering the booming late 1990s, have complained that the S&P 500 has only generated a meager average annual return of 12 percent over the last four years. While we would agree recent market returns have not kept pace with the rise in earnings, we are quick to point out that, unlike the 1990s, companies are now earning real profits and generating cash flows above their return on invested capital. Furthermore, the returns since 2002 are still above long-term historical averages. In fact, if we could sustain similar types of returns over the next twenty years, the Dow Jones Industrial Average, which broke through 12,000 in 2006, would be over 115,000!

To put it in terms of dollars and cents, if you invest $10,000 today in a savings account earning 2 percent, in twenty years you would have roughly $15,000. However, if you invest that $10,000 in the stock market and earned 12 percent in twenty years, your investment would be worth over $96,000.

Fear Factors
Even though returns have been robust in recent years, earnings growth has far outpaced market returns. Why is this? We believe market returns have not kept pace because ever since corporate profits started taking off, many market participants have been concerned expectations were too high. At the same time, analysts on Wall Street became markedly conservative with their earnings estimates in the post-Sarbanes-Oxley/Eliot Spitzer era. Because of this, a slowdown in profit growth has been anticipated since 2003 and this slowdown fear has muted stock returns. Furthermore, other factors, such as 9/11 and investor pain from the dot.com bubble have put a ceiling on investor’s sentiments and thus the market’s upside as well. On the flip side, stocks have not become overpriced either and this is a strong reason why we remain moderately bullish on stocks heading into 2007.

Review of 2006: Patient Bulls
Weather Second Quarter Storm
Nearly all of the old Wall Street adages came true in 2006. First, there is “So goes January, so goes the year,” and appropriately, January’s performance turned out to be a microcosm of how stocks would perform for the year. In both the first month and full year, volatility increased as we transitioned to a period of slower economic growth. However, there was a general upward trend in prices and it paid to be overweight in stocks versus bonds.

Because of the increased volatility, both market bulls and bears looked smart and not so smart at times last year. Some of the factors that market bears cited in 2006 as reasons for lower stock prices included speculation that the economy was headed for a recession, that energy prices and subsequently inflation would skyrocket and that the new Fed chairman, Ben Bernanke, would excessively raise interest rates. When the second adage came true, “Sell in May and go away,” and the S&P 500 index declined 7.4 percent from May 8th through June 13th, the bears’ claim seemed to be correct.

Despite these stock declines during the second quarter, by October 31, 2006 the S&P 500 index was up over 12 percent year-to-date. It was the market bulls that were now looking smart, as fears of an impending recession, out-of-control inflation and excessive Fed rate hikes turned out to be overblown. As we began the home stretch of 2006, the Democrats regained control of the House and Senate. The shift in power away from the Republicans could have market implications in 2007; however we believe market fears about a Democratic takeover will prove to be overblown as many of the newly elected members could be classified as fiscally conservative.

2007: Conditions Remain Favorable For Stocks
Bullish and bearish factors can be made about any market issue. Think of these factors as clouds in the sky. Some people are happy to have the refuge of a cloud on a hot, sunny day; others are disappointed to have the warmth of the sun blocked by a cloud. Who has the bullish view? Who has the bearish view? Many strategists, including ourselves, are forecasting that economic growth will slow. Do you consider this news to be bullish or bearish? On this issue, those with a bearish stance expect economic growth to slow rapidly to the point of an economic recession. Our bullish stance expects economic growth to slow at a moderate pace. Our projection is for GDP growth to moderate to 2.7 percent in 2007 and then to reaccelerate to 3.3 percent in 2008. Therefore, we agree with the Street consensus on the direction the economy is headed, but our research indicates the slowdown should not be as steep as many expect. Last, because of the moderating growth in addition to well-contained inflation, we anticipate the Fed will leave short-term interest rates unchanged in 2007.

The housing market is one of the main factors that should contribute to slower growth. After the tech bubble of 2000 and the 9/11 terrorist acts, the Fed did its part to boost the economy. In doing so, the Fed reduced interest rates to very low levels. One by-product of the Fed’s policy was a home construction boom. Refinancing loans increased as investors were able to lock in more attractive interest rates. These attractive rates also created housing demand that caused prices to soar. Consumers had access to cash via a housing ATM. Unfortunately, the housing supply eventually increased faster than demand. Home prices started to cool as interest rates rose and the housing ATM was slowly taken away from consumers. Everyone knows about the housing decline. Most believe this decline will continue at a quick pace; our bullish view expects the worst of the housing decline to be over. If we are incorrect, this issue could be an unexpected lightning bolt in our market forecast.

A similar economic scenario has played out in the oil market. As the price of crude oil peaked near $80 a barrel in July, supplies of inventory grew faster than demand. The excess supply created downward pressure on energy prices causing the price of crude oil to fall nearly 25 percent off peak levels. Our research suggests a continued decline in energy prices in 2007 is possible as supply should continue to outpace demand in the near-term. However, starting in 2008, new production will diminish and the production decline rate will rise. This lower productivity means less supply will be available. Less supply and increased demand should push oil prices into a new cycle upwards. Therefore, enjoy the cheaper energy prices now, because we do not expect them to stay down for too long.


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On the earnings front, we continue to believe the Street is underestimating productivity gains and the effects of globalization on corporate bottom lines. Our forecast is for the S&P 500 to post 10 percent earnings growth in 2007. If this occurs, it will mark the 6th consecutive year of profit gains and 5th consecutive year of double-digit profit gains for the index. While potential lightning strikes, such as renewed terrorist activity, a significant slowdown in growth in Asia, a greater than expected decline in housing, higher than expected inflation or even a hedge fund liquidity crunch could threaten our forecast, those risks remain minimal in our view.

Hot and Cold sectors for 2007
Of the ten sectors within the S&P 500, we recommend investors give strong considerations to overweighting telecommunication and industrials, underweighting healthcare and energy and maintaining neutral positions in all other sectors. Our strategy reflects the underlying fundamentals in each sector based on our long-term approach to valuation.

Sectors to overweight
The telecommunication sector had the best returns in 2006 and the data we are currently collecting indicates a continued upside for the group. We base this on relative valuations, high dividend yields and strong cash flow generation for telecom companies. Additionally, consolidation within telecom has allowed for margin expansion via synergies and cost cutting.

The industrials sector is another sector we recommend overweighting in 2007. Unlike the telecom sector, the industrials underperformed the S&P 500 index in 2006. One reason the sector lagged was because of the fear of an impending global recession. We believe these fears are overblown. Considering that a lot of bad news has already been priced into certain industrial stocks, we think there are many attractive long-term investment opportunities in the sector.

Sectors to underweight
In the healthcare and energy sectors, we are recommending investors tactically underweight these groups next year. Commodity prices in the energy sector retreated from peak levels in mid-2006 and certain energy stocks fell in response. We believe that the further decline of oil prices due to increased supplies coming on the market will cause the energy sector to lag the broad market. As for healthcare, the Democratic takeover of the House did not change our view on the sector. We had been concerned about the mid-term election six months before investors cast their ballots. Although the Democrats have a largely anti-industry agenda, we expect more rhetoric than action. However, the rhetoric risk does make us less interested in managed care and pharmaceutical-related industries.  

Put On Your Swim Gear
Our stock market forecast is based on fundamental data that is on our radar screen as of November 2006. Our research supports that the bullish case for owning stocks outweighs the bearish case heading into 2007. We acknowledge that our moderately bullish forecast for stocks does not foresee all sunny skies ahead and is precisely the reason we only predict slightly higher than average stock market returns in 2007. Remember economic conditions can and do change and it could cause us to tactically recommend reducing stock exposure. However, we believe that is not a likely scenario at this time. Therefore, we advise you to put on your swim gear and jump into the stock market pool, as we expect the Dow Jones Industrial average and S&P 500 to reach 13,500 and 1,525, respectively by the end of the year.