The Outlook for 2007:
'Reasonably Pleasant'
Strategists See Modest Stock Gains
And Soft Landing for the Economy
December 22, 2006
The consensus outlook for the U.S. stock market in 2007 reads like a Southern California weather report: sunny and mild, with barely a chance of clouds.
In a recent Russell Investment Group survey of 87 money managers, 86% said they expected stocks to rise in 2007, and just 12% said they expected the market to fall. Nearly a third expects stocks to rise 10% or more, while only 1% expects a 10% decline. "Underpinning managers' confidence is a growing conviction the Federal Reserve Board has achieved a soft landing for the U.S. economy," wrote Russell chief portfolio strategist Randy Lert.
Where will stocks end 2007? Has the Fed brought about a Goldilocks economy? Join the discussion.In a much smaller survey of a dozen strategists this week, The Wall Street Journal Online heard that same belief repeated over and over again. So powerful is the sentiment that many of last year's pessimists have capitulated, including Richard Bernstein, Merrill Lynch's famously bearish strategist, who recently forecast an 11% gain in the S&P 500 next year.
But Mr. Bernstein and a few other strategists -- including Goldman Sachs' Abby Joseph Cohen, who describes the market environment as "reasonably pleasant" -- warn that volatility may return to the market next year after a long, blissful period of complacency. That could set the stage for a less-pleasant 2008.
Here, in descending order from the most-bullish to the least-bullish (and you'll notice there's not much difference between the two, unlike last year's survey), is a sampling of strategists' opinions about 2007. All but Citigroup's Tobias Levkovich were interviewed, either by telephone or email. We included Mr. Levkovich because he was part of the survey last year.
After you read their views, share your own.
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Prudential Equity Group
Edward Keon, chief investment strategist
New York
S&P 500-stock index: 1630
Federal funds rate: 5.25%
The stock-market environment Mr. Keon sees when he gazes into his crystal ball is as Goldilocks as it gets: He expects a strong economy in 2007, but not too strong, keeping the Federal Reserve on hold. In fact, he expects the Fed to bring the economy in for a soft landing -- a rare occurrence in recent decades. "They seem to be doing a nice job," he says. He expects decent wage growth, encouraging consumer spending, but not so much that it fuels runaway inflation or hurts corporate profits.
He thinks stock prices, when measured against corporate earnings, are near their historical averages, at roughly 15 times next year's expected earnings, implying that stock-market returns will also be average -- 10% or so.
And he is not bothered much by the fact that most forecasters seem to agree with him -- something a contrarian might see as a sign of excess bullishness. "What matters is not what our opinions are -- it's what people who have money are doing," he says. And so far this year, he says, U.S. investors have, on net, pulled money out of U.S. stocks in favor of money-market funds, bond funds and foreign investments. That means there could be plenty of cash still available to fuel a rally.
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Citigroup
Tobias Levkovich, chief U.S. equities strategist
New York
Dow Jones Industrial Average: 14000
S&P 500: 1600
Though his targets are somewhat lower than Mr. Keon's, Mr. Levkovich is in some ways more bullish. In a recent note, he said his firm's various models -- which mash up investor sentiment, earnings, prices and other factors into various possible scenarios -- had come up with a possible year-end 2007 S&P 500 target as high as 1738.
Mr. Levkovich, whose forecasts for the Dow and S&P were just a bit too low last year, also points out that 2007 will be the third year of President Bush's second term. Historically, stocks have performed better in third years than in any other year of a presidential term, and several strategists expressed some level of belief it could hold true next year.
A falling dollar should also be a boon to big U.S. companies doing business overseas, he believes. Like Ms. Cohen, he expects volatility to return to the market after years of calm, but thinks that could create "a buying opportunity," especially in information-technology shares.
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Oaktree Asset Management
Robert Pavlik, chief investment officer
New York
DJIA: 13533; S&P 500: 1553
10-year Treasury yield: 4.5%
GDP growth: 2% to 3%
Core CPI, year-over-year: 2%
Oil: $55 to $63 a barrel
Mr. Pavlik expects a selloff early in the year as investors take profits from the 2006 rally. "Everybody's very concerned the market is overbought and waiting for a pullback," he says. "It will be a self-fulfilling prophecy."
But later in the year, he thinks, signs of a slowing economy will inspire the Fed to cut rates. Meanwhile, he believes, oil prices will continue to fall, the housing market's bleeding will stop and a recession will be avoided. Corporate profits will slow, but not disappear.
"Once prices get readjusted for that slowdown, the market will be feeling more confident," he says. Among the beneficiaries could be companies that thrive in the late stages of an economic cycle, including industrials. Fed rate cuts, meanwhile, could give banks a lift.
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Goldman Sachs
Abby Joseph Cohen, chief investment strategist
New York
DJIA: 13500; S&P 500: 1550
Ms. Cohen was one of the most prescient forecasters in our survey last year, predicting slowdowns in housing and the economy, but also seeing rallies in the Dow and S&P 500 to 12000 and 1400, respectively.
She describes the economic environment this year as "reasonably pleasant," but her outlook for stocks is "a little less enthusiastic" than it was last year. Economic growth will be slower, stocks are just a smidgen more expensive than a year ago and corporate profits will likely slow down, especially in the energy sector. This need not spell doom for stocks, however. "We believe this deceleration takes pressure off of inflation and interest rates and helps stretch out the economic cycle," she says, "and that's good news for the stock market."
She also thinks the market's current complacency could wane next year, possibly causing investors to shy away from riskier stocks. In this environment, she favors big companies with strong balance sheets and decent dividends. She also expects faster economic growth overseas to give a lift to U.S. exporters.
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Wells Capital Management
James Paulsen, chief investment strategist
Minneapolis
S&P 500: 1550
Federal funds rate: 6%
10-year yield: 6%
Unlike most forecasters in this survey, Mr. Paulsen doesn't see a Goldilocks economy next year. In fact, things will likely get too hot, in his view, with the Fed and bond market "panicking about inflation" by the end of the year.
He expects stocks to "explode" in the first half of the year, with the S&P 500 possibly hitting 1675, driven by excess liquidity, relatively cheap stock valuations, low interest rates, a booming economy and a last-minute rush for stocks by investors who worry about "missing out" on the bull run.
He expects core inflation to rise to more than 3% by the end of the year, well outside the Fed's supposed "comfort zone." He thinks the dollar will keep tumbling, adding to inflation worries. His forecast for interest rates is the same as it was last year: 6% for both the fed funds rate and the 10-year note yield. "Well try this again," he jokes; his forecast was too high for 2006, but he thinks the inflation scare will do the trick in 2007.
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A.G. Edwards & Sons
Stuart Freeman, chief equity strategist
St. Louis
DJIA: 13700; S&P 500: 1550
Nasdaq: 2630
GDP growth: 2.5%
Mr. Freeman believes that, barring any confidence-shaking geopolitical events, stocks could rise even higher than these targets. In fact, he has raised his targets slightly since publishing his last strategy note for the year on Dec. 11.
He expects the economy to slow below its potential growth rate in 2007, but believes that will be music to the ears of an inflation-watching Fed, keeping labor costs and price pressures in check. The Fed could make three quarter-percentage-point interest-rate cuts next year, he thinks, making the stock market happy, as well.
Like most other analysts, Mr. Freeman expects a long string of double-digit earnings growth to come to an end, but without causing stocks to fall. His favorite sectors for early 2007 include energy, consumer staples, industrials and health care -- hardly the stuff of rip-snorting bull markets.
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National City
Tim Swanson, chief investment officer
Cleveland
DJIA: 13500; S&P 500: 1525
10-year yield: 4.75% to 5%
Mr. Swanson's year-end targets for 2006 were nearly dead-on. A year ago, he expected the Fed to stop raising interest rates and high energy prices to fade, and he was right on both counts.
His prediction for 2007 is less benign, including a slowdown in corporate earnings and an overhang of "potential storm clouds." But he thinks stocks are still reasonably priced and set up for a ho-hum year of high-single-digit or 10% growth. "I think the stock market will do OK, but not fabulously well," he says.
He admits that his view is more or less the consensus view, and that makes him nervous. But he is comforted by what seem to be reasonable valuations for stocks. "Unlike the bull market of the 1990s, in which a period of extraordinary optimism was reflected in very high valuations on financial assets, I don't see that today," he says.
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PNC Wealth Management
Jeffrey Kleintop, chief investment strategist
Philadelphia
DJIA: 13400
S&P 500: 1525
Fed funds rate: 4% to 4.5%
10-year yield: 4.6%
Like other forecasters, Mr. Kleintop expects stocks to gain roughly 10% this year as the economy slows. He, too, cites the third year of a presidential term as a potential catalyst for stocks.
His outlook for corporate-profit growth, however, is significantly lower than that of many of his peers -- while others expect high single-digit growth in earnings, he expects earnings to grow just 3%. That's what typically happens after a Fed credit-tightening campaign, according to his research. But he also notes that stocks have typically rallied smartly after the end of Fed campaigns in recent decades, even as profit growth has slowed.
His favorite investment themes include international stocks, rather than U.S. equities, and companies that seem poised for fast profit growth, rather than slower-growing, but modestly priced, companies.
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Standard & Poor's
Sam Stovall, chief investment strategist
New York
S&P 500: 1510
Fed funds rate: 4.5%
GDP growth: 2.3%
Like most of his peers, Mr. Stovall is "embracing the soft-landing scenario," and he thinks the economy will rebound in 2008. He is more sanguine about corporate profits than many strategists, believing they'll get a lift from share buybacks -- which naturally raise the level of earnings per share -- and the falling dollar, which helps the profits of multinationals.
He also thinks stocks are priced too cheaply and says his firm's technical analysts believe the market is due for a small, 5% correction, followed by a 15% to 20% pop. And he takes comfort in history, pointing out that stocks typically rise after the Fed starts cutting rates. Like others, he too has some belief in the presidential-cycle theory.
But he is also a little anxious about the fact that the vast majority of his fellow strategists all have the same rosy forecast for the economy next year, saying inflation poses a real risk to the happy consensus. "Everybody else is saying the same thing" about the economy, he says. "Wouldn't that be a surprise if we all got it right?"
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Briefing.com
Dick Green, chief executive
Chicago
DJIA: 13200; S&P 500: 1510
Fed funds rate: 4.75%
10-year yield: 4.80%
Mr. Green also expects the Fed bringing the economy to a nice, soft landing next year, to the credit of Chairman Ben Bernanke. "I believe [predecessor Alan] Greenspan would have kept tightening and gone too far," he says.
Mr. Green thinks GDP will slow in the first half of the year, but "return to normalcy" by the end of the year. He also thinks inflation will moderate a bit, preventing the Fed from cutting interest rates many times.
"The current widespread optimism is justified," he says, "but some clouds will arise in the second half of the year" -- namely, a slowdown in profit growth to 7% or less, a far cry from the double-digit gains of recent years.
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CyberTrader (Charles Schwab)
Kenneth Tower, chief market strategist
Austin, Texas
DJIA: 13000 to 13500; S&P 500: 1500
Mr. Tower was the most bearish of our forecasters last year, calling for a 23% drop in the Dow to 8250, saying too many investors were bullish and that the bull market that began in October 2002 had gotten long in the tooth. "2006 has been a very surprising year," he admits.
He still believes the current bull market is pushing the outer edge of its life span and that a bear market is due, but now expects that to be a story for late 2007 or early 2008.
"It's a prevalent pattern for bull markets to end with narrow market rallies, and we don't have that right now -- everything but the Nasdaq has been going great guns," he says. "That's why I don't think that we're on the verge of a bear market." But he warns: "This long bull market does not mean the laws of supply and demand have been repealed. Bear markets still exist."
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Ritholtz Research & Analytics
Barry Ritholtz, chief investment officer
New York
DJIA: 13250; S&P 500: 1475
Nasdaq: 2650; Russell 2000: 825
10-year yield: 3.95%
Last year, Mr. Ritholtz semi-famously ended up as far and away the most-bearish of 76 forecasters surveyed by BusinessWeek, calling for a 36% plunge in the Dow by the end of 2006.
That forecast didn't quite work out, but Mr. Ritholtz also expected a "parabolic" rise in the Dow before the crash -- he got that part right, at least. "What we didn't get right was the timing," he says.
Mr. Ritholtz's forecasts for 2007, in contrast, are safely nestled in the bosom of Wall Street consensus. But he still expects a correction in the major indexes, with the Dow dropping 14% by midyear, before rebounding by the end of the year. Markets are "overbought, and as the economy starts to slow, the risk of a correction is out there," he says.
