From the January 2007 issue of Investment Advisor • Subscribe!

January 1, 2007

Happy New Year

Our market strategy panelists see a slowing but healthy economy and market

When it comes to predicting what's going to happen in the economy and market over the course of a year, the best prognosticators, of course, are those folks who live and breath these issues. Thus, we've turned to Investment Advisor's trusted panel of monthly asset allocation experts to give us their take on what investors can expect in 2007.

The general consensus among the panelists is that the U.S. economy is in for a soft landing, meaning, as Mark Keller of A.G. Edwards puts it, "the economy's rate of growth will continue to slow into 2007, staying north of recession." Most panelists also agree that inflation will be less of a threat this year than it was in 2006. Continued uncertainty, some panel members opine, will stem from the war in Iraq and energy prices.

At the Federal Open Market Committee's (FOMC) December 12 meeting, the Fed stated that "inflation pressures seem likely to moderate over time," adding, however, that "some inflation risks remain." The Fed decided at the meeting to leave the Federal Funds rate at 5.25%. In announcing its decision, the Fed said that economic growth has slowed over the course of 2006, "partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over the coming quarters."

Most members of our asset allocation panel interviewed by the IA editorial staff also concur that while a lot of rumblings on various issues will be voiced in hearings held by the Democratically controlled Congress, not much will actually get done--specifically as it concerns fixing Social Security. Some action, however, is likely to take place on the Medicare prescription drug plan, known as Part D. Democrats want to give the secretary of Health and Human Services (HHS) the power to negotiate prescription drug pricing.

As for taxes, some panelists doubt that the Democrats will be able to challenge President Bush's tax cuts, though some modification to the Alternative Minimum Tax (AMT) is more likely to occur because there's bipartisan support for reform.

Following are the panelists' predictions for 2007, along with a listing of those panelists who came closest last year to forecasting the actual market and economic numbers as of early December 2006. Most panelists last year thought the dollar would be strong relative to other currencies in 2006. As we now know, the dollar actually weakened substantially. This year, the panelists collectively opine that the dollar will indeed weaken, though it's not expected to collapse.--Melanie Waddell

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Lincoln Anderson

"Worry About Your Winners"

Of all the experts on IA's Asset Allocation panel, Lincoln Anderson stands out with the most aggressive allocation to equities--80%--for the new year. Anderson has advocated a hefty allocation to equities for about 18 months, he says, because when the Fed started to tighten he thought there was more risk attached to bonds, while equities had "the fundamentals, cost controls, and a growing economy that I thought would drive profit margins and total profits. As the P/Es were tumbling and the stock market [was] taking risk away, that also tilted me toward equities," says the Boston-based chief economist and CIO of Linsco/Private Ledger (LPL).

"The chief question right now is not so much stocks and bonds, though that's critical; the really important issue is, 'What is your bet in equities?'" By that Anderson means which equities: not so much cap size but rather value or growth and foreign or domestic stocks. It's important to remember, he says, the lessons of the recent technology and growth binge-and-bust, and look at where the big equity returns have been in the last six years: it's been "all about value, particularly small-cap value, but large-cap value too; energy, materials--tremendous performance; large-cap foreign--great performance; emerging markets, REITS--tremendous performance."

Anderson is looking for the economy to keep chugging along, for the current large jump in corporate tax receipts to help ease the budget deficit; the low dollar to help bring down the trade deficit; and with little change on the political front until after the 2008 presidential election, he is "looking for '07 to be a 3% real GDP growth year," with inflation easing a bit and the Fed pretty stable.--Kathleen M. McBride

Mark Balasa

Modest Overweight in Small Caps

The Alpha Group's Mark Balasa believes the economy is on a "firm footing" in many ways, and that current corporate earnings growth and job creation form a nice basis for the equity market in 2007. "We're still modestly overweighting small-company stocks," he says. Balasa, a principal with Balasa Dinverno & Foltz in Itasca, Illinois, who gathers data from the Alpha Group of advisors, suggests sticking with international stocks in 2007. "We think the Dow is going to weaken, which will help international investments in terms of currency. It will be a tailwind for international," he explains. "Foreign economies seem to be improving more than people expected, and they have more upside in the short term than the U.S. market does."

As for inflation, Balasa isn't concerned. "It's probably higher than it has been in the last five or six years, but it's still under control," he says. "Maybe around a 3% range, but nothing alarming."

With Democrats in control of Congress, Balasa believes trade policy and tax laws will change, and not for the better. "With the Democrats coming into the House and Senate and the pressure for their constituencies--unions and organized labor--there's probably going to be more restrictive trade rules. That's going to be challenging for entrepreneurs and business in general, and it's going to complicate the trade framework," he points out.

Balasa suggests keeping an eye on small caps. "They've had a seven-year run; at some point they're going to lose."--Kara P. Stapleton

Richard Bernstein

Japanese Consumer Market Looks Strong

In his U.S. Strategy Update published in November 2006, Merrill Lynch's chief investment strategist, Richard Bernstein, listed 10 themes that he feels are appropriate building blocks for the next 12 months. He argues that the U.S. consumer sector may be secularly slowing down after a long, strong run, but that consumer-sector opportunities in Japan are starting to intensify. The Japanese credit cycle is beginning to revive and if the Bank of Japan allows the credit cycle to mature, which it appears to be doing, early-cycle stocks are likely to outperform. Additionally, Bernstein reports that homebuilding, retailing, and similar groups, which have not been market leaders in Japan for many years, may pull ahead. "All in all," the report reads, "Japan's consumer sector seems to offer better opportunities than those available in the highly levered, very speculative U.S. consumer sector." Furthermore, a global arms buildup appears to be progressing as defense spending continues to rise around the world, fueled by economic and political tensions and the increased threat of terrorism. Substantial economic growth and rising global commodity prices have exacerbated those tensions, he says, but have also provided the liquidity necessary for a number of countries to fund arms buildups of their own, and in the past five years, global military spending has surged by 25%, led by the U.S., and will continue to do so in 2007.

For investors interested in U.S. consumer stocks, Bernstein suggests focusing on media, which has been one of the prime turnaround industries during 2006. In our 2007 outlook survey, he estimated the inflation rate at 1.5%.--Kara P. Stapleton

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Gail Dudack

A Fan of U.S. Equities

"I think the markets and the economy will do better than most people expect in 2007," notes the principal of the Dudack Research Group, "particularly in the first half of the year." She says that those who feel there's a weak economy usually attribute it to housing, but she has a different view. "Although there's currently a huge focus now on the weakness in the consumer sector driven by the residential market, I believe there's a lot of strength in other parts of the economy that will offset it," she says. "The bottom line is that there is better job growth and better income growth, and these things are actually very supportive of the consumer even if housing prices are flat."

Dudack adds that prospects are good for very modest inflation in 2007 as gasoline and overall energy prices come down. She advises keeping in mind that in a modest-inflation environment, what most investors will miss is that there is plenty of room for P/E multiple expansion. "While earnings growth may come down to single digits, which it will have to do sometime, that may not be as big a factor as the fact that low inflation expands multiples in 2007," she explains.

When it comes to asset allocation, Dudack plans to overweight equities. "U.S. equities are the best assets anywhere in the world," she says. "With the inverted yield curve and the narrow credit spreads, I think bonds are probably the highest-risk assets right now."--Kara P. Stapleton

Mark Keller

Heading for a Soft Landing

The chief investment officer of A.G. Edwards says the U.S. economy's rate of growth will continue to slow into 2007, staying north of recession and resulting in a soft landing. But the economy will "reaccelerate" before year-end, Keller predicts. Inflation will "be less of a problem" than in 2006, he says, projecting that the current 3% inflation rate will run about 2.0% in '07.

Like other panelists, Keller believes there will be lots of "posturing" going on in Washington, but not much will get done. "We'll finish the year with the same tax laws we started the year with," he says. He adds that the Democrats' attempts to modify the Medicare prescription drug benefit, Part D, to allow the government to regulate pricing will likely get vetoed.

When it comes to overweighting particular asset classes or sectors in '07, Keller says his favorite asset class is large-cap domestic stocks because valuations are low. But Keller "has concerns" about emerging market, small cap, and junk bond valuations. "Even though they've done well, we think risks have increased."--Melanie Waddell

Stuart Schweitzer

Cooling Job Market, but Overweight Large Caps

Stuart Schweitzer expects the U.S. economic slowdown to continue into early 2007, mainly because "we're just on the cusp of whatever spillover there will be from the weaker housing market" in 2006. While '07 will be a slower year for the economy, Schweitzer of JPMorgan Asset Management says, the new Congress will voice a lot of "displeasure" about the current state of many affairs during Congressional hearings, he predicts, but "I don't expect the Democrats to have a sufficient majority to challenge the Bush tax cuts."

The job market is also likely "to cool down a bit" causing consumers "to pull in their horns," leading to "a much needed pause in order to arrest the inflation threat and create a better platform of growth in the future," Schweitzer says. He sees the dollar weakening moderately in 2007, particularly against the yen, but the likelihood "of a major depreciation of the dollar is very slim." The yen "has not participated along with the euro in the advance against the dollar."

In 2007, Schweitzer recommends overweighting large caps. He would also overweight non-U.S. equity by a hair for three reasons: valuation, particularly in Europe; continued corporate restructuring outside of the U.S.; and the potential for a boost to returns from a moderately weaker dollar.--Melanie Waddell

Gary Shilling

A Recession in Q2?

It's unlikely that anyone will ever confuse Gary Shilling with an optimist. Based in Springfield, New Jersey, he's an economist and advisor who is also a regular columnist for Forbes. He's historically been less than bullish on the stock market and sees nothing in the current environment to change his mind, mostly due to difficulties in the housing market.

"We've already seen a big drop in sales," he says adding that after 18 to 24 months on the market, even homeowners in the deepest denial ultimately accept that their houses are not worth what they thought. By the time that moment comes, Shilling predicts that single-family home prices will have dropped by around 25%. "They're already down from the peak around 6%," he points out. "That will be very tough on the economy because so many people have depended on house appreciation to bridge the gap between income growth and much faster growth in their spending. If that comes to pass, I rather suspect that we'll see a recession starting with the second quarter of next year and lasting the balance of the year and maybe into '08."

Because of the uncertainties he sees in housing, Shilling is leaning toward long Treasuries. If he has to be in the stock market at all, his picks are "high-quality utilities," not because he thinks they're winners, but more because they provide a safe haven through their dividends and high yields.--Robert F. Keane

Liz Ann Sonders

A Long Term, Strategic View

One tax that most agree needs to be reviewed is the alternative minimum tax (AMT): "Nobody thinks that's a good tax," says Liz Ann Sonders, the chief investment strategist at Charles Schwab, who was on the President's Tax Reform Commission. "The problem that we found in trying to eliminate [AMT] under any kind of revenue-neutrality mandate is that it's expensive. It's very easy to say we ought to eliminate it but the impact that that has on the budget, to the extent that you don't find offsets, is quite damaging."

Sonders believes there will be a move to a more "fundamentals-driven" track for 2007. "Valuation is quite reasonable right now; maybe cheap is too bold a word, but at 16 times earnings in a very low inflation environment, that's very reasonably valued." Inflation is lower, she argues, because "oil prices [are] lower and even the rent component of core CPI" has fallen. Investors looking for the Fed to cut rates, though, may have to be patient, because "the first [rate] cut may be a little further out in the distance than maybe what the market hopes for right now."

Individual investors would be better served if advisors and clients could "focus on long-term strategic planning" rather than "the short-term tactical stuff, which more often hurts than helps them."--Kathleen M. McBride

Sam Stovall

A Smooth Ride Ahead

The chief investment strategist for Standard & Poor's offers a pretty upbeat assessment of prospects for the new year, with a prediction that the company's benchmark, the S&P 500, should offer a return close to 10% for 2007.

Stovall thinks the economy will offer a pretty smooth ride, so his suggested allocation is for 60% stocks (2/3 in U.S. equities and 1/3 overseas) and 40% in fixed income. In terms of bonds, S&P is suggesting a move toward longer durations as a potential hedge.

While real GDP growth is expected to decline slightly in 2007 to 2.3%, due to a combination of Federal Reserve rate increases, high oil prices, and the housing market slowdown, Stovall thinks inflation will also continue to drop. Economic growth in 2007 is more likely to be "investment-led rather than housing-led as in the past few years."

"The big worry that I have is that 2007 is the third year of a President's term in office, which is usually very, very strong," for the overall market, "up 18% on average, versus 9% for all years," says Stovall. "Historically it's worked whether you're looking at a unified government or one that's in total gridlock, but I really just wonder how strong Bush is at all. His popularity is less than 30%, Congress has gone against him, and we have a huge deficit, so how much stimulative spending can we do? We can't equate him to Nixon and Ford...more like Eisenhower, where we saw an 8% gain that year."--Robert F. Keane

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