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Sometimes the best way to divine where a market is headed is to listen to individual voices amid the roar of the investing crowd. But whose voices? We picked five individuals who have made their way through bull runs and bear attacks for decades. Our panel includes people with international perspectives and those who collectively work alongside a wide range of professional investors: One works for a hedge fund, another for a British asset manager, two for U.S. money managers, and the fifth for a research shop.
Their consensus: Investors should do fine with U.S. stocks, but to do better they'll have to pick the right companies and wade into other markets. Not surprisingly, all have misgivings and caveats, too.
"You're going to have a pretty good market in 2007," says Jason D. Trennert, chief strategist at Strategas Research Partners, who has boosted his credibility lately with prescient calls. He warned early this year that emerging-market stocks were too high; they plunged in May. And over the past two years, when others predicted slowing U.S. earnings growth, Trennert remained confident. Good call: Earnings per share for companies in the Standard & Poor's (MHP) 500-stock index rose at double-digit rates for a record 18 quarters in a row through September.
Now, Trennert expects the pace to decelerate alongside the overall economy. He predicts that earnings for S&P 500 companies will rise about 6% in 2007, vs. about 15% in 2006. But he also expects softening in the economy to prompt the Federal Reserve to ease short-term interest rates in May, which would probably make stocks more attractive. In fact, Trennert expects investors to be willing to pay up for stocks. Right now they trade at an average of about 16 times earnings; he sees that multiple rising to 17. Overall, he says, the S&P will be at 1,530 by yearend 2007, up nearly 9%. "It could be higher, if anything," he says.
Trennert concedes that he's predicting a Goldilocks scenario in which economic growth slows just enough to let the Fed ease but not so much as to kill earnings growth. He'll be wrong if things turn out too hot or too cold.
What to buy? Megacap U.S. stocks, which he calls "the cheapest asset class in the world." Especially appealing are big techs with strong balance sheets and products to sell to corporations making capital investments. Microsoft Corp. (MSFT) is his prime example. Look also to oilfield-services companies, he says. Even if economic growth slows, they'll benefit as the world makes up for years of underinvestment in oil and gas exploration. He likes Schlumberger Ltd. (SLB), a giant in that business. And "as a flier" sensitive to lower interest rates, Trennert recommends homebuilder Toll Brothers Inc. (TOL). Builder stocks have already been marked down a lot for the housing slump. "Even if the economy slows, [Toll's] high-end customer is going to be in good shape," he says.
With $6 billion under management and 20 years of experience running money for pension funds and high-net-worth individuals, New Amsterdam Partners founder Michelle R. Clayman doesn't mind saying that she, too, believes the economy will follow a Goldilocks scenario. It's slowing to a steady 2% to 2.5% pace for next year, she says, which will be just right for buying stocks at current prices. "We've seen the worst of inflation, and at the same time, you have decent productivity growth and [profit] margin expansion." Oil prices are moderating, and companies are operating more efficiently thanks to info tech, outsourcing opportunities, and slower hikes in labor costs.
Clayman's bullishness is also based on stock valuations being reasonable. The last time the S&P 500 traded around its recent 1,410 was six years ago, when earnings from companies in the index were only about 60% of today's level. With so much more profit backing stocks now, Clayman says, "the U.S. market is fairly valued to undervalued." She doesn't see the economy slowing enough to undermine the earnings stream. And while she's wary of executives becoming less vigilant about keeping up their earnings momentum, she doubts that will happen. "Companies continue to be very good at cutting costs and improving the way they run their businesses."
At this point in the economic cycle, she says, don't bother with stocks of companies whose fortunes rise when the economy is picking up speed--they've already had their run. Instead, look for companies with more specific stories. For example, Clayman likes Merrill Lynch & Co. (MER) as a play on the boom in leveraged buyouts and fees from dealmaking. Merrill is also harvesting gains from consolidating acquisitions it has made over the years. The stock "is relatively cheap," she says. It trades around 13 times next year's earnings, compared with a market price-earnings ratio of 16.
She also likes retailer Best Buy Co. (BBY) for its angle on consumer electronics. Sales are getting a boost from demand for flat-screen TVs and video-game platform upgrades. The hitch is that the stock recently traded at around 17 times next year's earnings--not cheap as retailers go.
A stock that's benefiting from the pursuit of productivity in manufacturing is ANSYS Inc. (ANSS). It makes simulation software to use with computer-aided designs, allowing companies to test virtual prototypes quickly. ANSYS' p-e is high at about 24, but profits are increasing by over 20% annually, so paying up is warranted, says Clayman. And more than 50% of the sales of the Canonsburg (Pa.) company come from abroad, which she says is a big plus: "Some non-U.S. economies will grow faster than the U.S. next year."
The two big Oakmark-brand international mutual funds that David G. Herro manages at Chicago's Harris Associates have done very well in the past five years:Oakmark Small-Cap International (OAKEX) is up 25% annualized, and Oakmark International (OAKIX) is up 17%. But Herro warns that those performances aren't sustainable. "It is not natural. The natural rate [for international stocks] is, like, 12% to 13%."
Why isn't Herro, who now manages $21 billion, feeling more like a confident victor? Herro, who describes himself as "neutral," says some of the recent gains result merely from currency translations after the decline of the dollar since March. He believes the dollar is unrealistically low now, and international stocks generally "are not cheap."
But he is finding values in blue-chip global companies, which he figures are trading for about 10 times their cash flow. That's a good level for financially strong companies with high returns, and it's down from 15 a few years ago. Examples include Switzerland's Nestl? (NSRGY), Britain's Cadbury Schweppes (CSG) and GlaxoSmithKline (GSK), and Germany's Daimler-Chrysler (DCX). Glaxo, the big pharmaceutical company, generates 30% returns on equity, boasts 30% operating margins, and has a dividend yield of 3.4%, he notes. Herro also likes drugmakers Novartis of Switzerland (NVS) and Takeda Pharmaceutical of Japan. Those stocks have been hurt by the prospect of government restrictions, he says, but "all of the negatives are in the prices. People are ignoring the long-term positives" of aging populations and unhealthy lifestyles.
Nestl? and Cadbury, makers of candies and beverages, are dependable businesses that generate steady cash flow. Their stocks would hold up well even if there's financial instability elsewhere, Herro says. He likes DaimlerChrysler as a turnaround story. That stock has suffered because its Detroit-based Chrysler lines are tainted by the decline of the U.S. auto industry. The penalty won't last, he argues, because Chrysler accounts for only about one-fifth of the company's value.
Some of Herro's recent wins have come from takeover premiums paid by leveraged buyout firms. But he's wary of how long that will last. LBO firms and hedge funds, he notes, have attracted lots of money, leveraged up, and bid up asset prices. At some point returns will slide, investors will flee, and the funds will have to unwind the leverage and sell their stakes. "The money coming out of these vehicles may strain the system," says Herro. "That's something to be cautious about."
When the veteran strategist calls himself "neutral" on U.S. stocks, it doesn't mean Byron Wien foresees a flat year. He expects the S&P to gain something like 5% to 10%, in line with earnings growth. But Wien doesn't find that prospect satisfying when set against the risk that investors are overconfident. "There's too much complacency, and that makes me apprehensive," he says. "The problem is that nobody is concerned about terrorism, our failure in Iraq, that housing will turn out worse, or that the trade deficit is inexorable and that therefore the dollar is doomed in the long run." But he concedes that the market is up this year, "and I can't ignore that."
Wien, 73, says he's looking for opportunities that go against the grain for Pequot Capital Management, the $7 billion hedge fund firm he joined last year after a successful 20-year run as a market sage at Morgan Stanley (MS). He won't disclose his specific picks but says: "I like commodities generally. The softer commodities--potash, corn, wheat, and soybeans--will do well." Why? Economic growth around the world is raising living standards, and that means bigger meals with more grain-fed beef and chicken. And he's watching for plays in oil, which, contrary to conventional wisdom, he predicts will go to $80 a barrel. Wien is also "warming up to health care." There's pessimism about those stocks because of concerns that Democrats in Washington may somehow impede earnings prospects. Wien, however, expects to see the sector invigorated by advances against Alzheimer's, heart disease, and cancer.
The best bets may well be overseas, in major industrialized markets. "I think Japan will surprise us," Wien says. Japanese stocks generally were the worst performers in 2006, so their prices could spurt to catch up. "They're operating a lot of facilities in China, and they're a clear beneficiary of growth in Asia," he says.
One of the most respected market watchers in the City of London, Michael Hughes is chief investment officer at Baring Asset Management, which manages $39 billion in institutional and mutual funds. He has seen a lot of ups and downs over his 33-year career. Nowadays he's generally positive about the global economic outlook. But the bigger gains, says Hughes, won't be had in Western countries. And he worries about easy credit bidding up asset prices around the world.
Hughes, 55, says the world economy is in the midst of a boom, driven by falling prices for goods and labor, that's capable of running 5 to 10 more years. The favorable environment has been created by the industrialization of China and India and the greater mobility of capital. Economic leadership next year will "shift from the West, and particularly the U.S., to Asia, Eastern Europe, and parts of Latin America," he says. China stocks will remain good bets. He also favors Japanese companies, especially small caps, which are less exposed to the strong yen because they tend to export less. Korea, Thailand, and Vietnam will do well, too, says Hughes, though the best way to play those markets is through diversified equity and bond funds.
Commodities continue to be a good bet, he adds, given the long run of growth he foresees. It's best to use vehicles that offer balanced exposure to oil, precious metals, and industrial metals, he adds, rather than funds focused on just oil or gold.
What could go wrong? The dollar, which Hughes thinks is fairly valued, could nonetheless take a sharp fall and trigger retaliatory action from Europe or Japan, ending the current period of economic stability. Hughes also warns that with borrowing for everything from corporate buyouts to houses running at high levels, the risk of a credit market accident that could destabilize the global economy is high. That's because the U.S. is using a lot of leverage, and many asset classes around the globe are expensive. As a result, the risk of asset price deflation is high, he says.
By David Henry, with Stanley Reed in London