Stocks Will Keep Rollin' in '07

Knight says he's investing more capital on so-called alpha strategies to augment returns, meaning his funds are taking more risk in stock selection and currency overlays -- "things that don't depend on the stock market just going up." Some of Knight's fund managers are using strategies such as the carry trade, borrowing low-yielding currencies to invest in higher-yielding assets, and other ideas typically associated with hedge funds.

Central to many strategists' belief in next year's returns is the bet, once again, that multiples are set to expand. Of all the asset classes that have benefited from the rising tide this year, the U.S. stock market remains the most undervalued, says Margaret Patel, portfolio strategist at Pioneer Investment, which has $6 billion in assets under management.

Risk premiums have reached peaks for many fixed-income investments, though. The average spread between yields on speculative-grade bonds, or junk bonds, and low-risk Treasuries, has hovered around 300 basis points. Spreads haven't crossed below that level since February 2005, and the historic low was 240 basis points in 1997.

The earnings yield of the S&P 500 -- the inverse of its price-to-earnings ratio -- is currently 6.02% based on the $85.14 a share in projected earnings for 2006 of all the companies in the S&P 500 Index and 6.39% based on estimated 2007 earnings of $90.38, according to Zacks. That compares very favorably to the yield on the 10-year Treasury, currently at 4.55%.

Indeed, Patel believes stocks are cheap relative to Treasuries and suggests buying growth sectors, including industrials, basic materials and utilities. Patel says health care is attractive as well and poised to grow, even though it is typically filed under the defensive category. She believes the durability of this year's stock market was due in part to investors' recognizing this value in equities amid relatively friendly economic conditions.

If investors become even less nervous about recession in 2007, their risk appetite for stocks may finally catch up to the risk appetite in fixed-income assets, leading to the long-awaited, much-elusive multiple expansion -- something almost everyone agrees would be very bullish for stocks.