Economic & Market Outlook for 2007
by Gerald Townsend, Financial Editor
 Lao Tzu, the 6th Century BC Chinese poet, aptly described our skepticism of futurists when he wrote: “Those who have knowledge, don't predict. Those who predict, don't have knowledge.” However, in defense of all the prognosticators out there, Nils Borh, a Nobel laureate in Physics, noted that, “Prediction is very difficult, especially if it’s about the future!”
Despite the difficulty of forecasting and the skepticism with which we greet it, the beginning of each year brings idea-hungry investors the annual ritual of crystal ball gazing by the financial media. So, with those cautionary words of warning, let’s plunge ahead and see what tomorrow’s headlines might be.
In 2006, the housing market finally collapsed but the economy did not. Interest rates drifted down and equity prices, after floundering for most of the year, found their footing and finally surpassed their pre-bust levels.
Looking into 2007, it appears that the much-discussed “soft landing” could actually arrive. The worst may be over for the housing market. Consumer spending is slowing, but in a gradual way. Bond yields could be flat or even declining somewhat given the easing in inflation expectations and with the Fed appearing to be through with rate increases and perhaps approaching a rate cut.
With equity markets hitting new highs, should investors cash in their profits and bail out? I don’t think so, as 2007 should be another year of positive returns. One reason for anticipating a good year for equities is demonstrated by “return on equity” (ROE), which is a measure of corporate profitability. Return on equity is calculated by dividing corporate profits by corporate equity (stock value). With corporate profits booming since 2002, ROE has soared to record highs. On the other hand, the price to book ratio (stock market value divided by book value) is below past peaks. Usually these two measures move in tandem, but at present there is a noticeable gap between them. Assuming this gap closes, it suggests an upward bias for the stock market.
 Two trends of the past several years that might finally run out of gas in 2007 are the relative out-performance of small capitalization stocks and value stocks vs. large capitalization and growth stocks. Stocks of small companies tend to exhibit better performance in the early stages of the economic cycle and we are now in the later stages of the current cycle. Therefore, stocks of the larger companies should finally flex their muscles and show better relative performance. In addition, assuming a slowing economy, companies that can grow their earnings should stand out from the crowd and give “growth” mutual funds the edge over the “value” funds.
Certainly this positive outlook for equities could be derailed by many things. Anything that undermines the confidence of investors, such as national or world political events or a substantial rise in oil prices, would threaten the market. However, given the expected softening of the world economy, any energy price increases should be within a range that can be successfully handled. Finally, 2007 will be the third year of the Presidential cycle, and historically, the third year exhibits a positive trend. As for the fourth year of the Presidential cycle – well, that’s another story.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com. |
