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Top Ten Predictions for 2007

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December 29, 2006

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Well, the markets are pretty much done for 2006. It was an excellent year for most markets with virtually all asset classes up across the board. The major US stock indices were up substantially for the year. Unfortunately, my overall predication that "defense" would be the best course of action in 2006 was incorrect (see Fortunately, the actual stocks I recommended did fine: CG (up 50.7% including dividends), SUG (up 20.2% including dividends) and VLI (up 14.2% including dividends), for an aggregate return of 28.4% for money equally invested (unfortunately, the growth in all of my holdings was more in line with the major US stock indices). In 2006, I switched jobs and my new position makes it impractical for me to post specific stock ideas on a message board. That is unfortunate because the posting was always done more for myself than for others (not to mention it is hard to believe that this type of posting could have any influence on the market). I found that the process of putting investment ideas into words sharpened my thought process and helped crystallize some of my better ideas. Further, looking back at the rationale of the investment sometimes helped me to stay the course (for instance, after weakness in the stock, I bought more VLI in April around the lows for the year).

Since I can not post individual stock ideas, I have decided to post some yearly, broad investment ideas (as the Wall Street investment strategists love to do and the macro haters here detest). If it is good enough for the high-paid Wall Street guys, here's to show what an unpaid amateur can do! Unfortunately, I find this advice to often be more harmful than helpful with respect to specific stock picks. Sometimes the analysis helps but I have talked myself out of several winning positions over the years based on some silly macroeconomic trend which had little to do with the individual business that I owned. But since this is all I can do and people seem to love this stuff, here are my 10 fearless predictions for 2007.

1. Oil prices will spike; Prices will be up moderately overall. Whether it is because of weather, geopolitics, OPEC cuts or some other shock, the world is going to realize the delicate balance between supply and demand that has emerged in our energy markets. This is going to cause prices to spike upwards at some point in 2007.

Investment Thesis: Go long oil; buy on dips; sell on any spikes.

2. The Yield Curve remains inverted; Long-term rates are stable. Significant demand from an aging population and global liquidity will keep the yield curve inverted. However, the Federal Reserve will not ease short-term rates more than 25bps because of inflation concerns. Therefore, the yield curve will remain inverted and long-term rates will be stable.

Investment Thesis: Short-term bonds will yield the most. Consider leverage to increase returns.

3. Major Stock Indices down mid to high single digits. A weakening economy and weakening fundamentals in the stock market will break the markets three-year winning streak.

Investment Thesis: Favor quality, special situations. Consider selling on strength, buying on significant (e.g. 15% or more) weakness to bolster returns.

4. International Markets provide no relief to return hungry investors. Weakening fundamentals in the international markets will also break the impressive winning streak they have had and frustrate investors looking for safe havens to hide in. Political risks will rise.

Investment Thesis: See Number 3 above.

5. Credit losses increase; No major credit shakeout. After years of below average defaults, credit losses will increase in 2007 but no major defaults/shakeout will occur.

Investment Thesis: Increase creditworthiness incrementally. Consider leveraging returns to high-quality credit exposure.

6. Residential housing sales volumes decline and prices fall. No major housing collapse. The housing market will continue to disappoint as sales volumes and prices continue to fall. However, there will not be any crises in housing.

Investment Thesis: Sell any recovery stories in housing.

7. Commodity prices rise; Agricultural prices standout. Once again, tightness in supply/demand balance will push global commodity prices higher. Agricultural commodities look particularly cheap (favorites are corn, wheat and sugar) while base metals (especially nickel) and energy prices will perform well.

Investment Thesis: Go long commodities.

8. Increases in labor and commodity prices will lower margins for US businesses. Increases in commodity prices and labor costs will pressure margins in a wide variety of businesses continuing a trend that started in 2005/6.

Investment Thesis: Be wary of businesses whose margins are vulnerable to price increases in inputs of production. Sectors that might experience problems are trucking, brokerage, food, restaurant and entertainment.

9. Faith in Ben Bernanke is tested. After the honeymoon period following his replacement of Alan Greenspan, the markets' faith in Ben Bernanke will be tested in 2007. Expect at least one incident where major market participants question Bernanke's leadership. In return, Bernanke will be reluctant to make any drastic policy moves.

Investment Thesis: Expect little policy change from Bernanke regardless of what the underlying fundamentals are.

10. A financial tremor will occur. There will be no major crisis. Much like living in a fault zone that has not experienced an earthquake in a while, a shock will come to the financial markets eventually despite the current complacency. Expect a minor tremor in 2007 but no major crisis.

Investment Thesis: Avoid extreme leverage or highly speculative investments.

And, as always, have a great year and happy investing!



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