After a bit of vacation and a very short trading week due to the holiday and President Ford’s memorial, we can begin with our official market predictions of ’07. Judging by the early returns from the economic numbers, an argument could easily be made that the economy is coming back to life. The employment report beat everyone’s expectations, however still managed to create fewer jobs than over the past 12 months. The Institute of Supply Management (ISM) reports showed some expansion in manufacturing and a modest decline in the service sector, again on balance a better than expected report. For the first time in a while, these key reports showed better than expected figures. Soon, the focus of investors will turn toward earnings and the retail figures from Christmas as well as the now important gift card season. We have already heard from Motorola (MOT) regarding their estimates and business conditions that are well below what Wall Street was expecting, keeping a lid on the early excitement of the new year. IF (and it is big) the first full week ends lower, look for more bearish comments to come out about the year.

Our models have been pointing toward a correction for some time, however the actual timing of the decline is not something we guesstimate. Our valuation models have been steadily in “high” territory, pointing to below normal returns over the coming three years. Also, our dividend and short-term rate model is also pointing to lower returns, although it has pointed to lower returns for the past three years. We can now add to that mix investor expectations – which are also high to the negative outlook for stocks in 2007. To be fair, the seasonal and presidential cycles point to a strong first half and weaker second half of the year. So where will stocks finish 2007? Our best guess is that stocks struggle to make headway and finish around where they started the year – with lots of rallies and declines throughout. 2006 was one of the lowest years for volatility in over 10 years; we don’t expect that to repeat in ’07. Our major asset class rankings point to favorable markets within the REIT and foreign areas – however even these two have enjoyed extended gains over the past five years. With many asset classes moving in the same direction over the past couple of years, we could see a return to “normal” conditions where there are clearer winners and losers.

We have been calling for a cut in the Fed Funds rate for more than six months and any cut in the future will likely be tied to the housing markets. The release of the minutes to their last meeting indicated that the Fed Governors were more focused on inflation expectations instead of the weakening growth conditions of the economy. Their steadfast commitment to fighting inflation caught the bond market off guard, as many believed there would be more concerned about the still weak housing markets. Our bond model improved a bit to a still negative “1”, pointing to higher rates in the future. The strong bond rally during the fourth quarter is likely in the midst of a correction that should allow us to add to current holdings to take advantage of what we believe will be lower rates later this year.

© 2007 Paul J. Nolte, CFA
Editorial Archive

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

CONTACT INFORMATION
Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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