Ninth Inning Comeback

Does the S&P 500's positive start to 2007 point to further equity price appreciation?

Investors are a lot like dieters: they look to January as a fresh start. Profit taking last year left many flush with cash, and this, combined with the desire to take advantage of the more favorable tax treatment offered by long-term capital gains, suggests to us that investors are likely to plow this money back into the market.

This logic has stood the test of time. The Stock Trader's Almanac first observed that since 1945, whenever the S&P 500 advanced in January, it continued to rise during the remaining 11 months of the year 85% of the time, posting an average price advance of 11.8%. That is substantially more than the 9% average annual return recorded by the S&P 500 for all years.

Heading into the last two days of January, the S&P 500 had advanced a mere 0.2% in the new year, reflecting concerns over the weaker-than-expected pace of fourth-quarter 2006 operating earnings, uncertainty over the Fed's next interest rate move, and the prospects for future wage inflation. But like a baseball team that scores the winning run on two outs in the ninth inning, the S&P 500 rallied more than 1.2% in the final two days of trading, as a statement by the Federal Reserve after the January FOMC meeting was less hawkish than many had expected.

The S&P 500 gained 1.4% last month - exactly equal to the average advance in January since World War II - and, thanks to the "January Barometer," generated optimism for the rest of the year. Of course, past performance is no guarantee of future results.

As seen in the accompanying table, investors may be surprised to discover that they could have reaped greater rewards by taking a cue from the three S&P 500 sectors or 10 sub-industries that posted the strongest results in January.

This January, the three best-performing sectors were health care, materials, and telecom services. The three worst performers were energy, financials, and utilities.

We think investors are increasingly concerned that additional interest rate increases may be required to slow economic growth and curb inflation. But S&P Economics believes that much of the recent economic strength was due to abnormally mild weather and that future economic indicators will point to a further slowing of U.S. economic growth.

In addition, we believe that inflation will remain contained, as indicated by recent inflation measures. As a result, S&P's Investment Policy Committee continues to recommend a 60% exposure to global equities and sees the S&P 500 advancing 6.5% on healthy, but slower, economic growth. We project a 9% rise in S&P 500 operating earnings for 2007 and believe it is possible the Fed will start cutting interest rates in the fourth quarter of the year.

January Barometer — 2007
Three Best Sectors Three Worst Sectors
Health Care Energy
Materials Financials
Telecommunication Services Utilities
10 Best Sub-Industries 10 Worst Sub-Industries
Construction Materials Consumer Electronics
Education Services Distillers & Vintners
Health Care Distributors Electronic Equipment Manufacturers
Home Furnishings: Retail Food Distributors
Office REITs Integrated Oil & Gas
Residential REITs Motorcycle Manufacturers
Retail REITs Property & Casualty Insurance
Steel Semiconductor Equipment
Tires & Rubber Thrifts & Mortgage Finance
Trading Companies & Distributors Wireless Telecommunication Services
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