Jeremy Siegel, Ph.D. The Future for Investors

No one can reliably predict the future, but I find the demand for such prognostications is so high that I am happy to offer you my thoughts about the coming year.

The Economy

Being right about the economy is no guarantee you are going to be right about the markets, but it is an important place to start. If the economy goes sour, there is no way stocks can move up. We are five years into an economic expansion that began in November 2001. Thirty years ago, that would have been considered long enough to worry about another downturn.

But no longer. The last economic expansion in the US lasted the whole decade of the 1990s and there is no reason this one cannot keep going as long, if not longer. The UK, for instance, has not had a quarterly decline in GDP (gross domestic product) for 15 years. As the developed world moves away from manufacturing to a service and information economy, sharp swings in manufacturing output have less impact.

Nevertheless, we are currently going through a mid-cycle slowdown, similar to what we had in 1995. That was also a time when the Fed raised interest rates after a period of very easy money. Today’s slowdown is caused primarily by the housing slump, but this will not turn into a recession. Although housing prices have come off their highs, the vast majority of homeowners still have hefty capital gains on both their real estate and stock portfolios.

With interest rates and gasoline prices stable, there is no reason consumers should not continue to spend and send the economy up 2.5% to 3% next year. This is slower the 3.5% to 4.5% average over the past three years, but enough to keep corporate profits rising.

The Stock Market

Everyone knows that stocks have had a great year in 2006. The S&P 500 Index returned over 15%, almost twice stocks’ long term average. Foreign stocks have done even better and the Morgan Stanley EAFE index of developed countries has returned over 26% in dollar terms.

Many emerging market have surged: stocks in China have doubled, while the very best stock market in 2006 was Vietnam’s Ho Chi Minh Stock Index, which is up nearly 150%. For those of us who grew up with the War in Vietnam, Ho Chi Minh, the communist leader of North Vietnam, represented the antithesis of American capitalism. Yet now its stock market is at the top of the heap. How the world has changed!

Markets here and overseas are still reasonably valued and corporate earnings should continue to move upward. Hence I believe 2007 will be another good year for stocks, although returns will not be as high as 2006. U.S. stocks should return about 8%, with foreign stocks doing perhaps a little better.

Earnings growth is driven by economic conditions abroad as well as at home and although U.S. economic growth may slow, the rest of the world is still expanding rapidly. I have been advocating at least 40% of one’s equity portfolio should be in foreign stocks, and there is no reason to change this recommendation.

Interest Rates

I believe that the Fed will hold interest rates at 5.25% for quite some time. There are many who think that stock investors are counting on a drop in the Fed Funds rate next year, and indeed the futures market does predict that short rates will fall.

But I don’t think investors need a rate drop to justify buying stocks. What stock investors don’t want is a rate rise, which, in my opinion, would sink stocks. Cash is now attractive relative to bonds – there are not many times that you get more than 50 basis points more on overnight money than you can by buying 10 to 20 year Treasury bonds, but that is indeed the case today. Yet stocks promise much better returns than either cash or bonds if current interest rates remain steady.

Politics

The Democratic takeover of Congress barely caused a ripple on the markets last November. But political developments in the next election will have a much bigger impact on the financial markets as the presidential candidates position themselves for the primaries that begin early in 2008.

This is because 2010 is a pivotal year for the U.S. tax system: the 15% rate on dividends and capital gains will expire as will the lower tax rates on ordinary income while the tax on estates will revert to the levels before the Bush 2002 tax cut. The Congress just elected will not enact new tax legislation, but the new President and Congress elected in November 2008 will have to settle these issues.

November’s victory means the Democrats hope to set the agenda for a Democratic presidential victory in 2008. Trade, the minimum wage, Medicare’s negotiation with drug companies, globalization, and the widening “gap” between rich and poor are sure to be Democratic talking points. These are going to be the hot-button issues going into the presidential campaigns.

Risks to Forecast

There are always downside risks to any economic forecast. Another major terrorist strike or a conflagration in the Mideast that disrupts oil supplies and sends the price of crude oil soaring will clearly have a negative impact on markets. With the housing market likely to be soft, if gasoline goes over $3 a gallon, the economy will slow and stocks will stall.

In the short term, the dollar could also be a risk factor for stocks. If the greenback breaks below its lows that it reached at the end of 2004 ($1.36 per Euro), that could precipitate some short term selling. I have often maintained that a “low” dollar is not bad for stocks, but a “falling” dollar can cause short-term instability. If several central banks try to reduce their dollar exposure, fearing a further decline in the dollar, this will send treasury bonds prices downward, raising yields and pressuring stocks.

New Year’s Forecast

These risks do not mean I am pessimistic. On the contrary, risks are unlikely events and the strength in the underlying economy points toward continued growth. It is likely that stocks will rise for a fifth consecutive year in 2007.