Markets: Where Optimism Reigns

Most investment strategists remain high on stocks, especially American ones

Stock investors say it's the best of times, bond mavens insist it's the worst. The tale of two markets rallying simultaneously poses two conflicting scenarios: Will the economy fall into recession, as the recent bond market rally seems to suggest? Or is it destined for a rare soft landing, with profit and economic growth merely slowing to more sustainable levels, as the stock market is signaling?

U.S. corporations have been charging ahead for a long time now. The fourth quarter could mark the 19th consecutive quarter of double-digit profit gains among companies in the Standard & Poor's 500-stock index. As a percentage of gross domestic product, those profits are at a 40-year high. What's more, cash flow at S&P 500 companies is the largest in two decades. Bullish investors, expecting more of the same in 2007, have bid up stocks: The S&P 500 gained 12.9% in 2006 through Dec. 8, the NASDAQ Composite Index added 10.5%, and the Dow Jones industrials tacked on 14.8%. Meanwhile, stock market volatility has plunged to a 12-year low, indicating that investor sanguinity has reached historic proportions.

But signs of trouble are mounting. The housing slump could worsen, taking consumer spending down with it. A key manufacturing gauge turned negative in mid-December, potentially warning of recession. And the crisis in Iraq raises questions about oil supplies and geopolitical stability. "There are a relatively large number of potential problems on the horizon, any one of which could derail things," says Timothy L. Swanson, chief investment officer for some $30 billion in assets at the private client group of Cleveland bank National City Corp. (NCC ).

This isn't the first time the stock and bond markets have sent contradictory messages. Westport (Conn.) research and money management firm Birinyi Associates Inc. found 16 such instances since 1982. In 100% of the cases when both stocks and bonds hit 52-week highs, stocks were up six months later, with an average gain of 8%. Bonds have been higher only 75% of the time, with an average increase of 4.1%.

NOT THAT HISTORY IS destined to repeat itself. That the bond and stock markets are rallying reflects "the complexity in the financial world today, and unfortunately that's the difficulty investors face," says Birinyi President Laszlo Birinyi Jr. "So many of these new issues are based on limited statistical observations."

There's no precedent for today's bond market, for example. When long-term Treasury bonds have yields lower than those of short-term notes, as they do now, it usually signals recession. But some bond watchers say the recent buying owes more to the insatiable desire of China, Japan, and other foreign nations to invest the U.S. dollars they collect from Americans in trade. And foreigners, they say, tend to apportion their investments across all bond maturities without regard for the economic outlook. "They are indifferent to the realties of our economies. They don't have anywhere else to go," says James Swanson, chief investment strategist at MFS Investment Management in Boston and manager of the $150 million MFS Diversified Income Fund (DIFAX ). "I don't see this changing. The yields are being pushed down by too much liquidity."

Most stock market watchers are banking on the so-called liquidity argument. Take a quick glance at our Fearless Forecaster survey, and you'll see that optimism reigns. Despite the many risks, say the bulls, the positives are too numerous to ignore. Record cash flows this year will be used in 2007 to invest in operations or to fund shareholder-friendly activities such as stock buybacks and dividend increases, both of which are expected to keep pace with those of the last few years. Merger mania continues to underpin stocks. Valuations are still nowhere near their late-1990s bubble levels. And with interest rates still quite low by historical standards, stocks seem like the best game in town.

SLOWING GLOBAL GROWTH, MEANWHILE, should bode well for U.S. investments. In the last several years investors have flocked to everything from gold to emerging market shares. "We think that's shifting now," says Gary Thayer, chief economist at A.G. Edwards & Sons Inc. (AGE ). "Investors are looking a lot more favorably on U.S. financial assets in both stocks and bonds." Adds Marc D. Stern, chief investment officer of Bessemer Trust in New York, which has $46 billion under management: "Our theme is that risk is mispriced. People are putting money in places they wouldn't visit." Stern anticipates a pullback from high-yield bonds as well as some emerging-market stocks and bonds in 2007 and a flight to the relative quality of U.S. issues.

Which stocks to buy? George F. Foley, a portfolio manager for the Glenmede Large Cap Value and Core Value funds, is leaning heavily toward materials companies, particularly well-known names such as Alcoa (AA ), Alcan (AL ), and Phelps Dodge (PD ) that he thinks can benefit from gains in efficiency. Merrill Lynch & Co. (MER ) chief investment strategist Richard Bernstein favors high-quality tech companies, discount retailers, global defense companies, and multiline insurers. He also likes industrials and telecom shares as the demand for raw materials and expertise increases in a burgeoning global infrastructure.

Tech seems to be a common theme for 2007. John B. Cunningham, chief investment officer at J. & W. Seligman & Co. (SCFIX ) in New York, likes hardware specialists such as computer, hard drive, and memory makers as consumer demand for electronics and capital spending by big corporations continue at a healthy clip. "The fundamentals are still very solid," he says. "We think tech can outperform the broader market." He also recommends telecom equipment makers as regional phone operators expand their systems to compete with cable operators.

DON'T FORGET FINANCIALS, SAYS Edward Yardeni, chief investment strategist of Oak Associates Ltd. He says the stocks of investment banks and asset managers are good ways to bet on merger mania and retiring baby boomers. And although energy has been one of the best-performing sectors in the S&P for the last three years, plenty of opportunities remain, he says. There's still momentum in the drilling, equipment, and services companies. "Look around," says Yardeni. "We have a capital-spending boom going on."

Internationally focused investors should expect global economic growth to slow but not to crash, and opportunities to persist. Developed markets seem especially cheap, trading at an average of 12.4 times expected 2007 earnings, compared with a 10-year average of 18.7, according to MFS. "There's still massive liquidity looking for a home, and valuations are still attractive in a number of markets," agrees Simon Davis, co-chief investment officer based in London for Putnam Investments. Davis says that while many China-based companies have been bid too high, it's smart to look at suppliers to an economy that continues to grow 10% a year. He favors mining and natural resources outfits in Australia, including Zinifex, BHP Billiton (BHP ), and Rio Tinto (RTP ), which is dual headquartered in Melbourne and London.

The likely losers? Bessemer's Stern cautions investors to stay away from housing-related stocks such as homebuilders, construction companies, and savings and loans. Although it may be tempting to think that there are bargains among them, he says "the profits they've posted in the last couple of years exaggerate their long-term earnings potential." Profit margins at small regional banks will keep being squeezed by higher short-term interest rates. And the pressure on companies to use their free cash to buy back shares and issue dividends rather than pay down debt doesn't bode well for high-grade corporate bonds.

The biggest risk to investors: inattention. Yardeni, who predicted the strong stock market of 2006, says the S&P could reach 1600 by midyear, a 13% gain, which will get investors worried about higher interest rates. And the ensuing sell-off, he says, will offer opportunity once again.

By Mara Der Hovanesian

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