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Follow These Signposts in 2007

David Merkel

Last week, in the name of good portfolio analysis, I underwent the exhausting process of rigorously examining the calls I made in 2006 and how they turned out. I got plenty wrong, but enough right to encourage me to stick my neck out and share what I expect to see happen in 2007. Hint: I've adopted a moderately bullish stance.

Here's why (I have a lot of related thoughts here, so I've organized them under each overarching thesis):

1. Bond yields will support equity valuations, as will record (or near-record) profit margins.

• It continues to pay over the intermediate term to buy back stock now.
• That said, companies at present not only are using their free cash flow for buybacks, they're levering up modestly to do so.
• Private equity is plentiful, and this will lead to more leveraged buyouts.
• Commercial real estate will continue to see a lot of buyout action.
• Profit margins are higher than the average by more than 2.5 standard deviations now. This can persist so long as international trade in goods, services and financial flows allows for the benefits of cheap labor to flow into the U.S. economy and for cheap capital to flow back into the U.S. asset markets.
• The third year of a presidential term is typically good for the equity markets.
• Low-quality equity outperformance will persist (four years running now -- I think that's a record) until we have some event that unravels the collateralized debt obligation and/or private equity bid for assets.

2. The CDO bid for risky debt is aggressive.

• Multisector collateralized debt obligations (CDOs) have gotten more attractive to issue recently, and the need for yield is great, so I see that persisting.
• All bond spread relationships are tight. Risk is not rewarded here. Systemic risk is under-discounted.
• Implied volatilities for most major markets are low. Yield-seeking is rampant, partially pushed by hedge funds of funds.

3. The trade deficit won't narrow soon.

• The dollar continues a controlled devaluation as the Chinese central bank continues its controlled appreciation of the yuan, carrying other currencies along with it.
• More small central banks will diversify away from dollars into the currencies of the nations they trade with.

4. The FOMC is probably on hold for 2007, stuck between inflation it regards as high, a growing economy and aggressive asset markets on one side, and on the other, inflation that many parties don't regard as being high and possible systemic risk.

• Excluding housing and autos, the U.S. economy will continue to grow, increasingly led by export-oriented sectors.
• Inflation won't accelerate markedly in 2007.
• Global yield curves will remain flat due to tighter monetary policy, pension reform and a need to recycle the U.S. current account deficit.
• Until something blows up on the liability side of bank balance sheets, M3 growth will continue to outpace growth of the monetary base.

5. The world is less politically stable than it was four years ago. More nations are pushing against U.S. hegemony. That may lead to some sort of crisis in trade, or even a war, but I rate that as a low -- yet still non-negligible -- probability, say 5%-10%.

Now, what could unravel my expectations? The major risk is some interruption of the global free trading system. There are moderate risks that defaults will begin to crop up from debts that have been issued over the past four years, but given the strength of the CDO and private equity bids, I don't see that happening until late 2007 at earliest. That said, I have my antennae up for defaults.

Though housing prices will continue to decline and foreclosures on residential housing will rise, that shouldn't turn into a systemic panic, though some local areas and industries (homebuilders and subprime lenders) may have a panic.

Finally, one can't count out the possibility that the FOMC (or another major central bank) might commit a policy error and overtighten. Over-loosening or premature loosening would be good for the stock market in dollar terms, but bad for the dollar.

On the whole, 2007 offers reason for moderate bullishness. Just keep an eye on the development of known problems in the global economic system. Strap in, and let's see what we can do in 2007.