The past few years brought heightened attention to foreign stocks and bonds, with a rising inflow into overseas investment funds. In the late 1990s, U.S. mutual funds were seeing an average of $640 million of daily inflows. From 2003-2005, the average daily inflow dropped to $360 million, according to TrimTabs Investment Research. During an average two-week period this past year, U.S. funds took in $1.2 billion of new cash, or about $170 million per session. What's more, 2006 saw approximately $175 billion of net cash funneled into global funds compared with less than $80 billion for U.S. funds. In fact, a total of $18.6 billion flowed out of U.S. equity funds during the second and third quarters. During the same time frame, $51.3 billion flowed into non-U.S. equity funds.
A potential surprise for 2007 would be for this global theme to be replaced by a domestic one, as inflows into mutual funds shift back to domestic soil. Investors succumbed to the siren songs of overseas action during the past few years as they played the odds of rising commodity prices and a slumping dollar. With bearishness on the dollar at a potential pessimistic extreme and commodity prices now universally expected to move higher, the current trends are vulnerable to reverting and leaving investors in these investments disappointed. Additional fuel should be added to the domestic market in 2007 as disenchanted expatriate investors return their interest to American securities.
Cautious optimism among institutional players and a market that has not yet impressed individual investors suggests that there is a reservoir of buying power, and the unwinding of low expectations should help maintain the market's current uptrend. Although the market hasn't faced a major correction since late 2002, the May 2006 pullback catalyzed a change in the sentiment backdrop, infusing the market environment with a heightened sense of caution. This set the stage for positive surprises, which drove the market to impressive double-digit gains from its July lows.
The increased presence of hedge funds enhances the probability of shallow pullbacks along the way. As more investors use hedge funds to guard against unforeseen market calamities, panics become less likely. Put support and short-covering scenarios will take an even greater role in keeping index exchange-traded funds atop levels of support.
Although the market averages are perched at or near historical highs, there are striking differences to the market's momentum seven years ago ahead of the bubble burst. Price-to-earnings ratios are more sensible, market strength is broad-based, and euphoria is under wraps.
Corporate earnings growth will subside somewhat, largely due to a retraction in earnings at energy companies, which will endure difficult comparisons to 2006. Growth of 10 percent is widely expected and thus slowing earnings growth is likely factored into stocks already. In addition, a moderation in earnings growth could set the stage for an easing of interest rates by the Fed.
The dollar is ripe for a bounce back amid extreme pessimism. If this were to occur, returns in overseas investing could diminish, sending investors back to U.S. equity funds.
Outperforming sectors that remain notably underloved due to their previous beaten-down status should continue to flourish. These include automotives and homebuilding issues.
I'd suggest placing about 60 percent of your investing capital in stocks, concentrating on financials, consumer durables, and housing stocks. Tuck 10 percent away in real estate investment trusts, and commit 10 percent to U.S. bonds. Finally, a solid 20 percent should be left in cash; the return on a short-term CD is currently about as good as the average dividend payout across the S&P 500 Index.
I would avoid energy, precious metals and overseas markets, which have become very crowded sectors that are also vulnerable to a surprise rally in the dollar.
More detail, please refer to http://www.schaeffersresearch.com/special/marketforecast07.aspx
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