2007 In a Nutshell

It’s the time of the year that analysts, pundits and plumbers weigh in to tell anyone who will listen what they think 2007 will hold for the markets. I am no exception to the rule and will devote today’s notes to reading my crystal ball.

Direction of the markets in 2007

For the first time since 2001, 12 out 12 of the largest investment banks on Wall Street have predicted that we will have an up year. Given their track record in 2001, it’s hard to feel comfortable about that, but let’s not forget there were extenuating circumstances in 2001 that no one could have predicted. I too forecast an up 2007, though I don’t think it will necessarily be as rosy as many others have forecasted.

I expect the S&P500 to end the year up 4% to 6% from its close in 2006. I also expect Small Caps to again outperform Large Caps. This is a contrarian view, but I believe it is supported by the law of large numbers. The last time Large Caps out performed, Mega Caps didn’t really exist as a category. Today’s Large Caps are more accurately defined as Mega Caps, and to grow their numbers enough to justify substantially higher valuations our entire economy would have to be much hotter that it is today.

Interest rates and inflation

Interest rate and inflation fears will again dominate the headlines, leading to manic bouts of greed and fear causing choppy and trendless trading much of the year. Inflation will likely subside, led by surprisingly weak energy prices, but upward wage pressures and a strong service economy will keep the employment market tight and the Fed nervous. My view of the big surprise for 2007 is that interest rates will be left unchanged longer than the market anticipates. I don’t believe the Fed will move until end of Q3 or Q4 2007, and which way they move at the time is a coin flip, given the potential for earnings growth that still exists this year.

Economic growth

The stratification between the service and the manufacturing economy in the United States will continue to widen. The service economy will remain strong, while the manufacturing economy led by housing and autos will progress into a deeper and deeper recession. GDP will surprise on the upside, dimming hopes of rate cuts at the year progresses.

Housing

Housing will finally stabilize due to persistently low interest rates which still make owning a house a better alternative than renting. Those who called for an all out crash will scratch their heads a lot and wonder why pessimists usually don’t make money in the markets. The bad news is that growth and write-offs of the big builders will continue to offer up plenty of disheartening news through out the year.

Currency

The dollar will continue to weaken against the Euro, but at a pace that will not cause catastrophic consequences to anyone in the economy, other than those planning a holiday to Europe.

Geopolitical

Here’s the wildcard. Just as in 2001, when all the analysts predicted up, the big risk to a down year lies in the risk of global turmoil, especially in the form of terrorism. The government in the United States has done an exceptional job of warding off would be terrorists, but with growing unrest in Iraq, Iran and Africa the probability of the unpopular policies of our government bringing adverse actions to our soil seems to be increasing.

There you have it, 2007 in a nutshell. Thank you to all my readers who made 2006 a great year. I look forward to keeping you entertained in 2007.