So said Doll in New York this week at a presentation of his annual “Ten Predictions” for the coming year regarding financial markets and the economy.
1. The US economy slows to between 2% and 2.5% growth as non-US growth remains relatively robust.
“We’ve been in a period of very strong synchronous global growth,’ Doll said, explaining why he sees a “soft landing,’ ahead. The weaknesses seen in housing “dents, but does not derail’ the economy, Doll commented. Since housing is only a part of the economy, the recession seen in housing currently will only take the U.S. down about 100 basis points from what otherwise would be, he said. Other sources of weakness that would lead to this slowing growth are excess inventories, industrial activity, the lagged impact of the record Fed increases, and an inverted yield curve. However, the positive strengths that will help the economy include, lower energy prices and the mild winter so far in the Northeast, strong employment and corporate balance sheets and the rising U.S. equity market and strong non-U.S. equity markets. Global growth, however, will be about 4% to 4.5%, he said, down from 2006’s level of around 5%. “That’s still very robust growth,” Doll said.
2. Earnings growth in the United States is below trend for the first time since 2001.
The U.S. has had a record five years of double digit earning growth, which he predicts will slow; although he clarified that he does not predict a reduction in earnings or a profits recession. Although profits don’t have to go down just because they are high, Doll said his prediction is because the record high levels are hard to sustain.
3. The US yield curve turns modestly positive as short rates fall and long rates rise.
Headline inflation has fallen considerably, he said; although commodity prices have been a negative, wages and other prices have been “well behaved.’ Therefore, he thinks inflation will remain “under control.’ Doll predicted that the Fed will begin easing rates mid-year (predicting two or three drops before the end of 2007), provided that the anticipated soft economic landing occurs. This will lead to a mediocre year for fixed income assets.
4. Equities experience another good year as price/earnings (P/E) ratios expand for the first time in six years.
Doll’s mainline view is that equities will have another good year, returning between 8% and 12%. The economy is strong, Doll said; “the absence of inflation and the Fed taking its foot off the interest rates pedal will help price-earnings ratios.” Therefore, he expects to see P-E expansion. Further, he said “it is no longer so obvious that the U.S. is going to lag the rest of the world,’ predicting that although the U.S. has been a consistent underperformer since 2003, in 2007, Doll thinks that domestic markets should climb at nearly the same rates as overseas markets. “In 2007, growth between U.S. financial markets and other markets around the globe will be more of a toss-up,” Doll said.
5. The average stock underperforms the broad market averages as large-cap and high-quality stocks outperform small-cap and low-quality stocks.
Large cap stocks are poised to outperform, Doll said, because they have started to exhibit stronger levels of earnings growth Growth relative to value is cheaper than normal, Doll said. He pointed out that in the long term, more companies in the S&P 500 underperformed the overall index. However, in the past five years or so, there has been significant outperformance, a trend that he thinks will change in 2007. Therefore, “While stock picking is always important, it’s going to become that much more critical to your portfolio in 2007,” he said.
6. The energy, healthcare and information technology sectors outperform the utilities, telecommunications and consumer staples sectors.
Energy is selling two standard deviations below its norm, which is one of the reasons Doll predicts it will increase, he said. Regarding health care, generally when the standard of living is going up, health care as a percent of GDP increases, which is the case currently. Technology spending has lagged corporate profits, and a catch-up is due, Doll said.
7. The US trade-weighted dollar moves to its lowest level in a decade.
The dollar weakness will come from weaker relative U.S. economic growth, unfavorable interest rate differentials and financial imbalances, Doll said.
8. Japan is the only major country to experience increased nominal growth, leading to equity market outperformance.
He predicts Japan, which “was a major laggard in 2006,’ will grow in 2007, adding a few hundred basis points. “They’re far more focused on productivity. The financial system has also improved noticeably,” Doll said. “And that will lead to relative financial market outperformance,” Doll said.
9. Volatility and return spreads increase from historically low levels.
Despite the correction seen in 2006, the volatility in the market has been quite low, Doll said, predicting that the slowing global economy, increasing global interest rates and the potential for unforeseen geopolitical events all contribute to increased volatility. However, this volatility will not always be negative, he said; there will be both up and down days. When volatility increases, quality does better, Doll said, relating this to his prediction that high-quality stocks will do better this year.
10. Populist politics experiences a renaissance in the United States.
Although his first entry into politics in last year’s prediction list did not turn out to be correct, Doll said he was venturing that way again saying that things such as increasing the minimum wage, eliminating favorable tax treatment of capital gains and dividends and increasing protectionist-oriented trade policies will all have dialogue around them, all of which can have an impact on the capital markets.
How He Fared in 2006
In recapping his predictions from 2006, Doll revealed he got 6 세 correct. He said although he was mostly correct in prediction the path for the economy and capital markets, he may have been ahead of the curve in predicting slower earnings growth and outperformance by large-cap stocks. Further, he said he was just plain wrong about believing the Republicans would retain control of Congress. Recapping his predictions from 2006:
Those he got correct:
- The overall U.S. economy slows to 3% growth as the front end (the consumer) weakens while the back end (capital spending) is relatively strong.
- The U.S. equity market experiences its first 10% correction since 2002, preparing the way for the second half of the bull market.
- The U.S. dollar resumes its downtrend.
- Led by Asia, non-US equity markets outperform US equities for the fifth year in a row.
- Strong cash flow leads to another year of high dividend increases, share buybacks and M&A activity.
- Commodity prices are higher again in 2006 than they were in 2005.
The half-correct prediction was:
- The U.S. yield curve inverts for the first time since 2000, while the U.S. 10-year Treasury trades with a “four-handle’ yield [yield between 4% and 5%] all year.
The three incorrect predictions for 2006 were:
- Earnings fail to meet the consensus expectation of double-digit percentage gains.
- Growth outperforms value and large outperforms small for the first time since 1999.
- Republicans retain control of Congress, but relinquish some of their advantage in the 2006 election.
Doll said he considered prediction 4, that of the market correction, his most important prediction of 2006. “It was the deepest correction we’d had in financial markets in virtually four years,” Doll said. Despite that, he continued, “equities turned out to have a very good year.”
What to Do
“If you agree with all this,’ Doll said, to translate his predictions into investment direction, overweight equities over bonds and, whether in stocks or mutual funds, favor high quality and large capitalization issues. Further, consider U.S. equity styles and sectors, especially the energy, health care and technology sectors which may be attractive investment opportunities, over the utilities, telecom and staples sectors.
However, don’t forget about international diversification, especially in the Japanese and Latin American markets, Doll said. If the dollar starts to weaken, as Doll predicts, he said investment opportunities will exist in non-U.S. markets, U.S. multinationals and products with a high percentage of earnings outside the U.S.