8 earthshaking surprises coming in 2007

By Jon Markman

Not one year in the past 1,000 has elapsed without surprises for investors, cowrie-shell traders or wampum dealers. But don't worry. This year you'll be armed with my list of unexpected events that will occur in 2007.

Bull market, year 5

Market historians will tell you that the current bull market, which began in October 2002, is now one of the longest in history. That leads bears -- who have shorted the market at a record pace -- to guess it is bound to fall apart in its fifth year, pointing in particular to the bull that began in 1982 and died in its fifth year in the great crash of October 1987. However, you need to realize that the current bull has been the weakest in history, averaging less than a 0.07% gain per day, according to researchers at Birinyi Associates. Compare that to the 0.17% daily gain of the August 1982-August 1987 bull market or the 0.15% daily gain of the October 1990-July 1998 bull. A slow, steady gain is not a bad thing; you can go farther walking than running. Despite loud rumblings from bears that consensus opinion, which predicts 8% capital appreciation for stocks this year, is too rosy, I think the surprise will be that it's not rosy enough.

Forecast: The S&P 500 will end 2007 at 1,602, up 13%.

Goldilocks lives!

In a truly shocking development, it will emerge over the next 12 months that the much-reviled Federal Reserve has actually been able to achieve its goal of quashing inflation by braking the U.S. economy without running it into a wall. In the past, virtually every multiyear campaign to raise interest rates has ended with a recession. In 2007, inflation will bubble but not boil over, the unemployment rate will rise to a tolerable 5.25% (from 4.5% now), the Fed will lower interest rates by half a percentage point, and U.S. economic growth will slow to a tepid but reasonable 2.6%. That level of growth is well below the 4% pace considered robust, but it's not an industry-annihilating, worker-devastating, consumer-abusing knockdown.

Forecast: Fed chief Ben Bernanke is celebrated in the fall with a Time magazine cover story anointing him as "Gentle Ben." The economy goes on to fully recover in 2008.

Heads will roll at S&P

You probably think of the S&P 500 Index ($INX) and the Dow Jones Industrial Average ($INDU) as interchangeable proxies for the performance of large-company stocks. Yet they are composed very differently, and the names behind them -- Dow Jones (DJ, news, msgs) and The McGraw-Hill Cos. (MHP, news, msgs), respectively -- are bitter competitors for the affections and dollars of index-licensing mutual funds. In 2006, the Dow rose a stunning 2.7 percentage points more than the S&P 500 -- 16.3% vs. 13.6%. That may not sound like much of a difference, but it cost S&P 500 followers many billions of dollars. The reason was largely incompetence by S&P managers. As I uncovered in pioneering research in 2001 and 2002, S&P 500 managers -- who are economists, editors and salesmen, not portfolio managers -- have a habit of impatiently throwing value stocks off the list when they falter and replacing them with highfliers. Inevitably, the stumblers recover and the highfliers collapse. In 2006, S&P made more mistakes of this type than usual, as the nine stocks it dumped from the S&P 500, such as Cooper Tire & Rubber (CTB, news, msgs) and Gateway (GTW, news, msgs), went on to gain 27% on average, while the 32 stocks it added, such as Legg Mason (LM, news, msgs), gained 1% on average.

Forecast: McGraw-Hill fires top executives of its S&P 500 team and orders the new managers to prize value over momentum.

Gimme growth

When the economy slows, companies whose fortunes are largely tied to gross domestic product growth -- such as large toothpaste, detergent and soda pop makers -- find themselves in hot water. They can reach into a bag of financial engineering tricks to increase earnings growth, such as buying back shares. But revenue growth and profit margins still shrink, scaring investors. At times like these, seasoned growth companies -- that is, ones that year after year innovate their way to above-average earnings gains -- are prized.

Forecast: Large-cap growth stocks that could lead the market in 2007 are Halliburton (HAL, news, msgs), headed for $49; Applied Materials (AMAT, news, msgs), headed for $25; medical services provider Baxter International (BAX, news, msgs), headed to $57; and cable TV provider Comcast (CMCSA, news, msgs), headed to $55.

Beijing on track

In the second half of the year, the media will start to focus heavily on the progress made by China as it prepares to host the Summer Olympics in August 2008. Beijing is trying hard to clear its filthy air and provide blue skies for athletes, but it is a tough battle as poisonously dirty coal-fired power plants provide most of the electricity for the fast-growing country's manufacturers and office buildings. After visiting China in mid-April last year, I recommended that investors bet on the cleanup by buying shares of microcap air-pollution control specialist Fuel Tech (FTEK, news, msgs), and it has risen 65% since, to $24. Now I'm going to suggest China will shock the world by actually getting the job done, even if it has to radically cut power production in the months preceding the games.

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