Looking Ahead To 2007: Where Can Investors Continue to Expect Stock Market Gains

By Gregory Solomon

In the course of 2006, the Dow Jones Industrial Average has gained about 12% and the S&P 500 index is higher by nearly 10%. Institutional investors are expecting that falling oil prices and the pause in interest rate hikes by the Federal Reserve will offset the downturn in the housing market. Their optimism has lifted the Dow Jones average to all-time highs and the S&P index recently posted its best third quarter since 1997. The positive performance of the stock market’s two leading indicators is also setting the stage for several other market indexes to post yearly gains for a fourth consecutive year. Furthermore, since the bear market officially ended in 2002, there are a number industry sectors that have outperformed the both the DJIA and the S&P 500 annually. This is in part, the result of the exceptional gains made by small company stocks, equity real estate holdings and global securities.

As we head into the new-year, any rise in inflation resulting from a rebound in oil will no doubt raise concerns of a slowing economy and may cause the stock market to pull back. Nevertheless, stocks should continue to outperform cash, bonds and real estate. However, with many stocks perched near their multi-year highs, any garden-variety geo-political event could certainly rattle the epileptic nerves of the investment community. Such news may increase the market’s volatility and result in a rotation into more conservative, defensive and large company stocks. Indeed, unlike most market rallies since 2000, large company stocks led the way in the market’s most recent rebound.

Right now, the stock market is four years into a bull market, which started in October 2002. According to the averages, bull markets typically last about five years. Because the market is poised to finish its fourth year in positive territory, odds are, that at the end of next year the market will also be higher. Historically, equities have gained 10 percent in the fifth year of bull market rallies. This scenario would include very little inflation and steady, but still positive, economic growth.

Therefore, in 2007, investors may do well to consider high quality, dividend paying stocks, as well as shares of companies with potential for growth in the global arena. There are still many investment opportunities internationally, where valuations are lower and a weaker U.S. dollar can enhance returns. Additionally, investors should consider mutual funds with exposure to commodities. Though the easy money in this sector is already in the bank, there is still the prospect that both China and India will increase consumption of basic materials as their economies continue to expand. Furthermore, since commodities are not correlated to the U.S. stock market, this strategy provides additional portfolio diversification.

Investors that are willing to take an optimistic view of 2007 may want to consider industries that have historically performed well during sustained periods of economic growth, such as the technology sector. While Wall Street has focused lately on the Dow's new record highs, it might be a surprise to learn that during 2006 technology stocks have actually underperformed the Dow Jones Industrial Average. The tech-heavy NASDAQ 100 index has returned about seven percent through the end of October. Compare that with the DJIA’s 12.7 percent gain. In fact, the NASDAQ index remains more than 50 percent below its all-time peak.

After more than seven years of being out of favor, many technology stocks are trading at attractive valuations. Additionally, this sector is generating significant cash flow, which is now resulting in improved balance sheets with very little debt. Furthermore, some of these companies have even started to pay dividends.

After years of cost cutting, many of largest U.S. companies are sitting on piles of cash and are planning to increase their technology expenditures to increase productivity. Since 2004, IT spending as a percentage of our economy, is gradually improving and is likely to move higher. Therefore, should economic growth in the U.S. begin to slow, the technology sector would be one of the few places where investors can get accelerated growth.

Currently, many large manufacturing companies are buying important new semiconductor products that were not available just two or three years ago. For example, several smaller technology companies now make processor companion computer chips that enhance performance by increasing memory and extending the battery life of components within cell phones, cars and home appliances.

The positive news surrounding the technology sector has recently gotten the attention of Wall Street. Even a number of value-oriented mutual fund managers, who have historically avoided technology stocks, are starting to increase their holdings in the technology sector. According to a recent survey of money managers by the Russell Investment Group, 56 percent are now "bullish" on technology stocks, versus just 18 percent who say they are "bearish" on the sector. As we look ahead to 2007, the investment community appears more optimistic about the technology sector than about any other group except healthcare.

Gregory Solomon is a registered investment advisor and the principle owner of Solomon Asset Management; Colorado Springs, CO. Greg is also a leading investment consultant responsible for the equity research at one of Worth Magazine’s Top 100 Wealth Advisors. The opinions in the preceding commentary are as of the date of publication, are subject to change based on subsequent developments. This material is not intended to be relied upon as a forecast, research, or investment advice and should not be considered a recommendation to purchase or sell securities.