Markets
Where to Invest in 2007
The winds are shifting in favor of large, blue-chip companies.
By Andrew Tanzer, Senior Associate Editor
From Kiplinger's Personal Finance magazine, January 2007
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As 2007 dawns, some shadows have fallen across the U.S. economy. Air is hissing out of the inflated housing market. Growth in corporate earnings is slowing from a sprint to a trot. The Federal Reserve, still worried about rising inflation, is reluctant to cut interest rates. Yet we remain upbeat about the stock market's prospects in 2007. Based on our economic forecasts and absent an unexpected shock (see Wild Cards), Standard & Poor's 500-stock index should return 7% to 12% in the coming year -- and perhaps more.
Flush with record profits, businesses will spend briskly. Robust capital expenditures will offset weaker consumer spending and help prevent the economy from sinking into recession. Easing inflation should permit the Fed to start trimming interest rates by mid or late 2007.
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Long-term bonds seem stuck in the 4.5% to 5% range, making them unattractive relative to stocks. Compare bond yields with the stock market's earnings yield (the inverse of the market's price-earnings ratio and essentially what the market would yield if it paid out all profits as dividends). Based on 2007 projections, the S&P 500 sells at 14 times earnings, so the earnings yield for stocks is about 7%, well above the yield of Treasury bonds.
Moreover, history teaches that the market cheers when the Fed starts cutting rates. For example, during a similar slowdown in the middle of an economic expansion in the mid 1990s, stocks surged after the Fed went to work, despite slowing growth in earnings. A combination of moderating inflation, falling interest rates and a soft economic landing are normally a recipe for expanding P/Es. That is why stock-market gains in 2007 could easily exceed 10%, even if profits rise only 7% or so.
Political factors
Another bullish element for stock investors is the presidential cycle. Historically, the third year of a President's term is an excellent one for stocks. Since 1945, the S&P has gained an average of 18% in third years, compared with an average of 9% in all years, says S&P strategist Sam Stovall. "The market anticipates that a President will try to get his party reelected by putting money into voters' hands," he says.
A complicating factor, however, is the capture of both houses of Congress by the Democrats. That means Democrats will set the congressional agenda for at least the next two years. It also means two years of divided government. Investors do not like political uncertainty, but they may not be perturbed by the idea of stalemate: a Congress controlled by Democrats balanced by a Republican President.
The more economically populist Democrats will scrutinize drug prices and take a harder -- and perhaps protectionist -- line on this country's mammoth trade deficits, especially the politically sensitive gap with China.
The next Congress will almost certainly try to boost the federally mandated minimum wage, pegged at $5.15 an hour for the past ten years. That could hurt fast-food chains, retailers and other service-industry companies that typically pay low wages. On the other hand, more than half of the states and the District of Columbia have already set a minimum wage that's higher than the current federal floor, so any congressionally mandated boost might not depress restaurant and retail stocks. Indeed, shares of McDonald's (symbol MCD) were above their Election Day close within two days.
