STOCK WATCH


What Now, Dow?

Manuel Schiffres

The best-known barometer of the U.S. stock market is flirting with a record high. It will break that record and keep going.



Hold those champagne corks. Investors obviously are suffering from a case of record-phobia. The Dow Jones industrial average once again flirted with surpassing the record high it hit nearly seven years ago and once again came up short. The Dow, in the public's eye the best known barometer of the U.S. stock market, closed at 11,718.45 on September 28, just shy of its record close of 11,722.98, set on January 14, 2000. With a new record almost inevitable, what better time to take stock -- pardon the expression -- of the market's health?

In truth, the Dow milestone is more a media event than a significant indicator of the market's past performance or its future direction. Most professional money managers who specialize in large domestic companies measure their success, or lack thereof, against the much-more-diversified Standard Poor's 500-stock index, which is still about 12% shy of its all-time high, set in March 2000. A new high is nowhere in sight for the technology-heavy Nasdaq index, which is 54% below its peak.

Still, it's reasonable to ask what the future holds for stocks now that the Dow is approaching uncharted territory. Our answer: More new highs are on the way.

This optimism is based on a variety of factors:

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1. The economy is coming in for a soft landing. Economic activity is slowing, but the economy is likely to avoid recession. Kiplinger's expects real economic growth next year of 2.5%.

2. As a result, corporate profits should continue to grow, although not as quickly as in recent years. The third quarter of 2006 should mark the 18th straight quarter of double-digit percentage year-over-year earnings gains. For the entire year, profits should exceed the 2005 figure by 12%. Figure on 6% to 7% total SP 500 earnings gains in 2007. True, investors will not be thrilled at the prospect of slower earnings growth. But by the middle of next year, they will start looking ahead toward an improving profit picture in 2008.

3. Interest-rate conditions will remain favorable. Yields on ten-year Treasury notes, which have plunged since June from about 5.25% to 4.63%, should bounce back to 5% early next year. But with energy prices more stable and inflation behaving better, look for the Federal Reserve Board, which controls short-term interest rates, to begin cutting those rates in the middle of 2007. That should support share prices.

4. Given the context of still-low interest rates and quiescent inflation, stocks seem reasonably priced. Even as the Dow and SP have stagnated since early 2000, corporate profits have advanced smartly (by the time 2006 is finished, earnings on SP 500 will have nearly doubled over the past five years alone). The market (as measured by the SP) sells for a little less than 16 times estimated 2006 earnings and a bit less than 15 times 2007 forecasts. Those figures are roughly in the midpoint of the historical average.

As always, there are risks to our relatively upbeat forecast. You know the usual suspects: terrorism, another war in the Middle East, a disruption in energy supplies that leads to a spike in oil prices, implosion of large hedge fund. One wild card that's hard to gauge is the downturn in housing prices. Turmoil in housing could result in weaker economic growth than we anticipate, perhaps even thrust the economy into recession. But the recent decline in long-term interest rates, off which mortgage rates are keyed, should help mitigate the decline in prices by making homes more affordable.

One risk we wouldn't worry too much about is the upcoming elections. Investors already know that there's a decent chance that the Democrats will capture at least one house of Congress, and they've continued to bid up share prices. So the risk, if you want to call it that, of supposedly free-spending, tax-raising Democrats taking power is already baked into stock prices. Besides, the GOP would still control the White House, and markets would probably welcome divided government, one that's unlikely to do anything that could harm businesses or the economy.

By now, you're probably on the edge of your seats waiting for a specific prediction on how far the markets will climb. Those who predict both a specific target price and a specific target date are just begging for trouble. But we'd be copping out if we didn't give our best guess. So figure on stocks rising another 3% this year, equivalent to a Dow of about 12,070. And by the end of 2007, the Dow should be knocking on the door of 13,000.

We continue to believe that large growth companies represent the most attractive part of the market. Investors should hold well-diversified portfolios that consist of large-company and small-company stocks, foreign and domestic shares and bonds, if appropriate. But if you're going to tilt your portfolio anywhere, it should be toward large-capitalization growth stocks. Among actively traded funds, good choices for riding this sector of the market include Marsico Growth (symbol MGRIX), T. Rowe Price Growth Stock (PRGFX) and Vanguard Primecap Core (VPCCX). If you prefer a passive, indexed approach, consider Vanguard Growth Index (VIGRX) among regular mutual funds and Vanguard Large-Cap ETF (VV) among exchange-traded funds.



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