Column by Jim Flinchum, Inside Business - Hampton Roads, January 15, 2007

This is an interesting time for a forecast because the stock market and the bond market are predicting very different things. The bullish stock market continues to break record highs, suggesting a strengthening economy. On the other hand, the bearish bond market continues to predict that long-term rates will remain low because the economy will be sluggish, with little need to borrow. Therefore, with equal amounts of confidence and trepidation, this is what I expect for 2007:

1. The sky will not fall. There will be no actual recession. Unemployment is already low at 4.5 percent and will not rise significantly. While GDP growth has already begun to slow, primarily due to the drag of residential real estate and the automotive industry, it will resume by the second half of the year. Corporate profits will continue to be healthy, if no longer at a double-digit pace. I predict a slowing GDP rate below 2 percent the first half of the year, recovering to 3-3.5 percent for the second half.

2. There will be lots of changes inside “the economy.” Since 9/11, most investment analysts have been predicting increased values for stocks of large companies (large caps). They have been right, but only since the “commodity crash” last May. Normally, there is a flight-to-quality in the face of a softening economy, which explains the increased popularity of large cap stocks. The Dow beat the S&P by almost 3 percent in 2006. The Dow is where mega-large companies are listed, which tells me that investors wanted the security of names they knew well. I believe the economic “landing” will be soft and investors will return to the traditional growth engines, i.e., small and mid-size company stocks by year-end. For the last three years, small cap stocks have appreciated 15.5 percent annually, while large cap stocks rose only 12.3 percent.

The best economic sectors of 2006 were telecommunications, followed by energy, materials, and consumer discretionary. I expect only materials to do well in 2007. The weakest sector was health care, followed by information technology and industrials. Health care is a traditional, defensively “safe” sector but should continue to disappoint until its many structural problems are faced. However, an improving economy in late 2007 should increase demand for technology.

Despite the alarming PPI numbers in late December, inflation is still trending downward here and internationally. Inflation gets out of hand in two ways. First, a sustained increase in demand that is greater than can be supplied. Because of globalization, supply is now much easier to increase for most products. Second, inflation breaks out when the money supply grows too rapidly. That is certainly not the case in the U.S. where our broad measure of money supply has only grown 5.1 percent compared to 8.5 percent in Europe. I predict inflation will remain modest at 2.0-2.5 percent.

My 2007 year-end market predictions are:
Dow (mega-large companies)
13,400, up 7%.

S&P (large companies)
1,575, up 9%.

NASDAQ (technology)
2,770, up 14%.

Russell 2000 (smaller companies)
920, up 16%.

EAFE ($) (broad international)
2,450, up 18%.

3. Globalization will slow but not stop. Foreign stock markets have significantly out-performed the U.S. market. Markets for emerging countries were up 26.7 percent (in dollar terms) primarily due to globalization, but also because of the falling dollar. If you believe, as I do, that the dollar will continue to weaken, then you will like the international portion of your portfolio.

Globalization actually helps the large multi-national companies in the Dow the most and has been their primary driver. One factor worth watching is President Bush's “fast track” authority, which expires in June. Without this, it is almost impossible for the president to negotiate multi-lateral agreements. I predict Congress will not extend his authority in June, but globalization will continue by the use of bilateral agreements, just less quickly or effectively.

The bull market for commodities has been driven by globalization and will continue to be a bull market. Volatility in commodities indexes has been skewed by the geo-politically sensitive energy commodities. We will remain in a long-term secular bull market for commodities.

4. Our economy will be tested. It may be another terrorist attack on our country or an outbreak of some kind like SARS or the bird flu. This will be THE test of our economy’s resilience. That economy is almost incomprehensively big and can absorb most anything. It promptly recovered from 9/11, and will do so again if necessary. The only thing that really worries me is a complete collapse in the Middle East, with Iran invading Iraq to protect the Shias, and Syria invading Iraq to protect the Sunnis, with blank checks from Saudi Arabia. If so, then I predict you will be happier owning cash instead of stocks, because I see nothing on the political horizon to break our “oil addiction”, as the president called it.

5. Shifting gears in Congress. It is unclear if “old” Democrats or “new” Democrats will decide future tax changes. A modest increase in the tax burden will not torpedo a strong economy and will have almost no impact on 2007. Likewise, I am not concerned about a modest increase in the minimum wage. However, if the preferential tax treatment of dividends is not extended, I will shift my portfolio away from “value” or dividend-paying stocks.

6. Shifting gears at the Fed. Monetary policy is controlled by the Fed, which may raise the Federal Funds rate one more time but only once. However, I don’t foresee more than two subsequent reductions before year-end. The yield curve will remain slightly inverted. Homeowners with adjustable rate mortgages should not be overly concerned, as those rates are not likely to increase much in a world of record liquidity levels and minimal inflation.

The dollar will continue to weaken as the trade deficit stays large, our interest rates remain relatively low, and foreign central banks wisely continue to diversify their holdings of foreign reserves out of dollars and into Euros and gold. This is also good for our exports (which were up 14 percent in 2006), even if mildly inflationary.

7. No help from Richmond for Hampton Roads. One of the most confounding economic challenges locally is the continuing political gridlock in Richmond. Poor transportation is a primary constraint on our growth, as well as a real safety threat in the event of emergency. (Would you re-locate a firm into an area where your employees cannot be safely evacuated?) My prediction is that we will enjoy our car radios even more and our elected politicians even less.

Overall, we may be experiencing what Fed chief Ben Bernanke calls “The Great Moderation,” in which wild economic swings in the future are unlikely. He credits sound monetary policy as the reason. Maybe so, the data seems to support that argument, but there are other possible causes. Whatever the cause, it is a good thing.

So, who is right, the bullish stock market or the bearish bond market? It is the stock market. The bond market is confused by the inverted yield curve, ignoring the world’s first savings “glut.” Throughout 2007, I predict we'll experience decreasing market volatility, which brings increasing comfort levels for investors and, therefore, higher market values.

Jim Flinchum, a CFP practitioner and certified investment management analyst, is the managing principal of Bay Capital Advisors, an investment advisory firm in Virginia Beach. He can be reached at 963-5699 or www.baycapitaladvice.com.