Perhaps Better Than a Soft Landing for Stocks in 2007?

The Fed met earlier this week and announced that they plan to keep the brakes on the economy as they fear inflation worse than they do a slowing economy. But there was room in their statement for hope that a cut would come in 2007 noting a “mixed” economic performance and describing the year-long housing slump as “substantial.”

Since then, the news has been mostly good on both the inflation and the economic fronts. The Labor Department reported that consumer prices held steady in November after falling for the two prior months. Economists were expecting an increase in the consumer price index after a 0.5 percent decrease in October. Core prices that exclude food and energy were also unchanged, the first month without an increase since June 2005.

Also today the government announced thatU.S.industrial production increased 0.2% in November, after a revised flat reading in October. Manufacturing output, which accounts for about four-fifths of total U.S .industrial production, rose 0.3% last month, following a revised 0.5% decrease in October. Yesterday, the Federal Reserve of NY reported that manufacturing growth in that state fell less than forecast this month as orders picked up.

Economists were further surprised and encouraged by retail sales reports which increased by a seasonally adjusted 1% during November. The data reassures that the economy is not slowing too fast and may indeed be in for a fourth-quarter lift.

The slumping housing industry got some good news this week too. Mortgage applications surged by 11.4% in the latest week as purchase applications jumped 8.7%. Refinancing applications bounced by 15.8% as reported by the Mortgage Bankers Association. But experts say that the economy as a whole is not likely to benefit from the home construction industry until mid-2007 at the earliest due to the large overhang of unsold new homes.

What about stocks in 2007?

Buckle your seatbelts. Our top equity strategist, Don Hays, suggests that the S&P 500 could rise almost 28% next year as the Fed eases interest rates and stocks finally catch up to bonds. He arrives at his number by positing that if earnings growth for the S&P 500 rises by just 5% next year the current year-ahead earnings projection increases from $94.89 to $99.63. If he is right, the market’s P/E would have to be only 18.3 times. He reminds us of the old market maxim of 18-22, which says that stocks are fairly valued as long as the P/E ratio plus inflation falls within a range of 18 to 22. The Fed is guaranteeing us that inflation is going to be less than 2%, so a rise in the P/E to 20 falls well within the maxim and with past levels.

The December rally so far has propelled the S&P 3.2% higher while the NASDAQ is 2.2% higher. European stocks are on a December winning streak as well as they reach fresh six-year highs.

The conventional wisdom is that large cap stocks will outperform their smaller peers in the coming year. They may be finally right, but too broad for much use. We believe that the best returns will come from growth stocks in general and technology, software, communication, and financial stocks specifically.

As for bonds, we believe that short term rates will trend down next year more than longer rates, but probably not enough for major gains on short bonds. The dollar’s gradual and necessary decline will keep rates from dropping as far as they might in the absence of dollar weakness.

Our models remain well diversified within our strategic allocation, but we have tactically weighted them toward the growth style in equities and for bonds, toward the shorter and intermediate positions on the yield curve. In our more aggressive all-stock models we have further concentrated among those industries we expect will see the best growth in the coming year or two – essentially technology.