Aging Bull
Can the market kick up its heels one more time?
It's as if Wall Street suddenly discovered Prozac.
On paper, there are plenty of reasons for investors to be anxious about the financial markets' prospects this year.
For starters, the global economic boom that drove international stock and commodity prices higher in recent years is starting to cool. Economists project global growth of 3.2 percent this year, down from 3.8 percent in 2006, while the U.S. economy will trail at about 2.5 percent.
Corporate profits, which have propped up stock prices here at home, are also expected to weaken. Earnings among companies in the S&P 500 index are expected to rise 9.3 percent in 2007, down from 15.4 percent last year.
And the stock surge is now over four years old, an age at which a typical bull market is put out to pasture.
Yet as 2007 kicks off, economists and market watchers are about as optimistic as they've been in recent memory. Eight out of 10 money managers polled by the Russell Investment Group predict that stocks will post their fifth consecutive positive year. One in three thinks the equity markets will return around 10 percent or more in 2007.
Jeffrey Kleintop, chief investment strategist for PNC Wealth Management, predicts the S&P 500 will climb to 1550 next year, about a 9 percent rise in the blue-chip index. Tobias Levkovich, chief U.S. equity strategist for Citigroup Investment Research, thinks the S&P could do even better-hitting 1600, for a 13 percent jump.
To be sure, high-single-digit or low-double-digit gains are simply in line with the stock market's historic average performance dating back to 1926, according to Ibbotson Associates. Last year, the S&P 500 returned 15.8 percent, its best year since 2003. And despite recession fears and a housing market slowdown, the Dow Jones industrial average hit a new all-time record in 2006 and is now poised to pierce the 13,000 level for the first time. "To hear investment managers tell it, Wall Street will belong to the bulls in 2007," says Randy Lert, Russell's chief portfolio strategist.
But "that's what bothers me," says James Paulsen, chief investment strategist for Wells Capital Management.
While optimism is always welcome, there's a fine line between confidence and wishful thinking. Jerry Webman, chief economist for OppenheimerFunds, says most market strategists, no matter their outlook for the economy, are finding reasons to be bullish about stocks.
"Oddly, the people who are bearish on the economy say that if the economy isn't great, the Federal Reserve will [cut rates] and the markets will be just fine," Webman says. "At the same time, people who say, 'Gee, the economy is much stronger than the headlines indicate,' think that earnings will stay strong and the stock market will be OK."
Optimism often leads to heightened expectations. And the greater the expectations, the greater the likelihood that the economy and markets will fall short.
This is why Stuart Schweitzer, global markets strategist for JPMorgan Asset & Wealth Management-who predicts stocks will rise modestly-says equity investors should brace themselves for "stomach-churning bumps."
Wall Street is already trimming estimates of corporate profit growth this year, Schweitzer notes. Six months ago, he says, analysts were forecasting S&P 500 profit growth of more than 10.5 percent. Since then, forecasts have fallen by more than a percentage point.
So, why are investors-who've historically preferred climbing walls of worry to ladders of hope-suddenly acting like Alfred E. ("What, me worry?") Neuman?
Part of it may have to do with history. This is the third year of President Bush's second term. Since World War II, notes Sam Stovall, chief investment strategist for S&P, the 500 index has never lost money in the third year of a presidential term. In fact, third-year gains have averaged 18 percent.
The bullishness may also stem from investors' recent experiences. There's an old saying on Wall Street: Investors tend to think that things will forever be the way they are.
Both the economy and corporate profits have recently proved far more resilient than expected. Last year, the economy weathered recession worries and a housing slowdown, as corporate America found a way to accelerate the pace of earnings growth. "Profits just continue to amaze analysts and strategists," says Jack Ablin, chief investment officer for Harris Private Bank.
Today, investors aren't simply banking on a so-called soft landing for the domestic economy. "The market is bracing for the plane to circle the runway and take off again," says James Swanson, chief investment strategist for MFS Investment Management.
This optimism is reflected in continued risk-taking among investors, Swanson says. Toward the end of last year, the best-performing segments of the market were the riskiest: emerging-markets stocks, small-company stocks, and commodities. Shares of blue-chip companies, which were expected to lead the market, wound up laggards yet again (Page 73). The average large-cap growth fund rose just 7.3 percent in 2006, while small-cap growth funds surged 11.1 percent.
Many on Wall Street think a change is in the air. A Russell survey found that money managers are most bullish on large-cap growth stocks and favor blue-chip foreign stocks over emerging-markets shares.
Of course, investors made a similar bet at the start of 2006 and turned out to be wrong. So how can you tell whether the markets will be in a speculative or safety-seeking mood this year?
Keep an eye on relative growth overseas. The developed economies of western Europe, Japan, and the United States are predicted to trail considerably behind growth in the emerging markets. Stovall expects 2 percent economic growth in the "eurozone" nations and 1.9 percent in Japan, compared with 4.8 percent in Latin America, 5.9 percent in Europe's emerging economies, and 6.8 percent in Asia's developing countries. If the emerging markets continue to outpace the developed world, it should be another solid year for emerging-markets stocks and other speculative assets.
Heed the bond market. Right now, all eyes are on the Federal Reserve as investors try to guess when the central bank will start to cut rates to jump-start U.S. economic growth. But the Fed controls only short-term interest rates. And long-term rates, set by the bond market, have been the real story as of late.
"This is the only time in postwar history where a recovery has taken place ... without any rise in long-term borrowing costs," Paulsen says. This economic expansion began in November 2001, with 10-year treasury notes yielding about 4.7 percent. More than five years later-and after 17 Fed hikes in short-term interest rates-10-year treasury yields are almost unchanged.
So long as long-term borrowing costs remain cheap, Paulsen thinks there's a good chance that money will find its way to higher-risk, higher-return assets like small-cap stocks.
Don't forget the Fed. So far, the bond market has all but ignored the Fed, but stock traders would be foolish to follow. Fed rate decisions tend to quickly change the stock market's mood. Since World War II, Stovall says, the S&P 500 has declined an average of 2.2 percent in the six months leading up to the first in a series of Fed rate cuts. Yet in the six months after the first rate cut, stocks soared 11 percent on average. And 12 months after the Fed began to ease monetary policy, the S&P 500 has jumped 18.5 percent on average.
Check housing prices. Unlike last year, many investors are betting that the worst is over-or close to over-in the housing market. The National Association of Realtors predicts median sales prices of existing homes will keep sliding in the first quarter of 2007, then rebound.
But what if prices continue to fall? That could spell bigger troubles for consumers-and that's a recipe for unexpected problems in the U.S. economy.
Might want to keep that Prozac handy.
This story appears in the January 15, 2007 print edition of U.S. News & World Report.