2007: A Look Forward

24 Dec

Here we are going into another new year. Seems amazing that another year has passed us by. At each yearly crest I realized how quickly time really does go.

I will quit waxing philosophical to deal with what I look for in the stock market in the year ahead. What will the market do and what companies or sectors might do well in 2007?

I must qualify my forthcoming statements by saying that I don’t think broad market predictions are worthwhile. If I get any of this right, it will have been from dumb luck and not clairvoyance. Putting one’s thoughts down on paper (or blogs), though, allows a person to reflect on past statements and determine what was right or wrong about an analysis. It’s useful to document one’s investment thesis or underlying assumptions when making investment decisions or developing projections. To do so allows one to more readily learn from past mistakes and to develop better analytical processes to hopefully avoid similar mistakes going forward.

The contrarian in me likes to look at companies that have been beaten down in the current year to find future winners. As I look at the Dow 30, I see five companies that haven’t really moved much this year. 3M (MMM) and Alcoa (AA) were basically flat; Wal-Mart (WMT) is down 2.9%; Home Depot (HD) is down 4%; and Intel (INTC) has been the biggest loser, down 19%. The worst performing sectors in the S&P 500 Index were information technology, health care, and consumer staples, though they are all higher.

Let’s start with next year’s winners. In this year’s discard pile, there are two I like – Wal-Mart and Home Depot. Each company is a past stock market darling whose stock has fallen on hard times. Both trade at a valuation that discounts overly pessimistic views yet these two companies are still growing well, enjoying high returns on capital, growing dividends, and share buybacks. I expect these two companies to benefit the long-term investor if purchased at these levels, though I will not give a timetable on when they will rally.

In the coming year, I suspect that the domestic stock market will do the better than most developed international markets. Emerging markets may continue to do well, as there remains an abundance of capital in search of investments. This depends on lot on how the prices of basic commodities hold up, as they are the dominant source of emerging market exports. U.S. investors in international markets in 2007 may face a headwind in the form of a rising dollar, which lies in contrast to this year. As of today, the MSCI EAFE Index is up 22.3% year-to-date in dollar terms, but in local currency it’s up only 12.7%. So nearly 10% of its 2006 return has been due to the declining dollar.

The dollar has been trampled this year and it seems all of the talk I hear about it is bearish. So I’ll take the opposite view and say the dollar will be up in 2007. A wild card is whether the Chinese will allow their currency (yuan) to float. If so, this would help reduce our trade deficit, which is bullish for the dollar. In addition to the dollar tailwind (for U.S. companies), financially strong large and medium sized companies stand to benefit the most if credit markets tighten significantly and world economic growth slows.

I think we could have another up year in the market, probably in the range of 8-12%. But I don’t think we can get this upside with the low volatility we’ve had since August. I think we’re going to be able to buy the market at lower levels, which obviously increases the upside for an investor buying on dips. That said, I don’t advocate trying to time the market. I for one am no good at it. I DO advocate paying close attention to the prices paid when investing in individual companies. If the market is not offering you a margin of safety, money markets pay you nearly 5% to sit on the sidelines.

I don’t see a lot of talk about P/E multiple expansion for next year. In fact, I hear many pundits on CNBC saying “we don’t see much multiple expansion in 2007.” This leads me to believe we will have some, but I think this will help to cushion returns, because earnings growth will not be as robust as expected. Multiples may expand as earnings grow moderately. A 15.5 forward P/E only has to move to 16.28 to add another 5% to the market’s total return.

The consumer is likely to remain strong in 2007. There is no reason to believe otherwise or to bet against them. Yes, the savings rate is flat-to-negative and home equity extraction has slowed significantly. But workers in general have not shared commensurately in the prosperity corporations have enjoyed recently and labor markets are tightening, leading me to conclude that wage levels will continue to ratchet higher and provide additional discretionary income.

Of course, discretionary income depends a lot on what energy prices do. Higher oil, natural gas, and gasoline prices leave less discretionary spending for the consumer. So where will prices go in 2007? Well, the low supply/growing demand argument continues to have merit. I’m not sure where the “normal” prices for oil and gas are, but under normal circumstances prices should approximate the marginal cost of production. The marginal cost of production is probably in the $20-40 dollar range (yes, it’s a wide range because its difficult to know for certain). The marginal cost is probably on the higher end due to higher drilling costs and a tight labor supply that have left the industry with higher incremental production costs. The prospect of serious supply disruptions keeps a premium on oil prices that I don’t think with abate soon.

It will be interesting to see how it plays out. Happy New Year.

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