Signs abound that 2007 will be good for equity investors. We’re coming into the third year of a presidential cycle, which is historically the best year for stocks. Earnings continue to dazzle analysts and investors; inflation, while above 2%, seems to be holding steady; and the housing market, once thought to be on life support, showed surprising resiliency in December.

The only non-believer seems to be the bond market. The current yield curve is inverted, an unusual scenario when the yield on longer-maturity government securities is lower than on shorter-term paper. An inverted curve has preceded each of the last six recessions since 1970; as a result, its utility as a precursor of economic trouble is well deserved. Bond participants seem convinced that trouble is ahead, and a shrinking economy would no doubt put a damper on rising stock prices.

But the world has changed a lot since the last inversion occurred in 2000. First off, the large pile of offshore cash committing to long-term U.S. government bonds has changed the structure of the yield curve. With more demand for longer-term paper, inverted curves will likely be more commonplace, especially in an environment of stagnant rates.

Nonetheless, analysts include the inverted yield curve in the models they use to predict future economic growth. Most of these econometric forecasts put the odds of a slowdown in 2007 at 30% to 50%.

I believe that these estimates are biased toward an indicator that, while historically prescient, probably doesn’t accurately reflect current market realities. It may seem that I’m saying “this time is different,” but it really is, as the yield curve first inverted in the fourth quarter of 2005. Then, the S&P 500 index was about 20% lower than it is now.

The Monthly Index Report for January 2007

Index

Dec-06

QTD

YTD

Description
S&P 500 Index*

2.93%

7.92%

13.62%

Large-cap stocks
DJIA*

1.97%

6.71%

16.29%

Large-cap stocks
Nasdaq Comp.*

-0.68%

6.94%

9.52%

Large-cap tech stocks
Russell 1000 Growth

0.34%

5.93%

9.07%

Large-cap growth stocks
Russell 1000 Value

2.24%

7.99%

22.25%

Large-cap value stocks
Russell 2000 Growth

-0.24%

8.76%

13.35%

Small-cap growth stocks
Russell 2000 Value

0.87%

9.03%

23.48%

Small-cap value stocks
EAFE

3.15%

10.41%

26.86%

Europe, Australasia & Far East Index
Lehman Aggregate -0.58%

1.24%

4.33%

U.S. Government Bonds
Lehman High Yield

1.10%

4.19%

11.85%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

2.37%

6.35% 5.48% Managed Futures
3-month Treasury Bill

4.91%

All returns are estimates as of December 31, 2006. *Return numbers do not include dividends. ** Returns are estimates as of December 28, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.