What will happen in 2007?
The irrational exhuberance that drove stocks to record highs in 2006 will stop at some point. This should not be a bad year for stocks overall, but there will be some nasty corrections along the way. It's a good time to increase your short positions.
Small caps are now overvalued across the board, though some bargains are still available in oil services, medical care, or some obscure beaten-down stocks. I expect the average smallcap to lose 30% of its current value at some point in 2007 before the stock takes care of itself by next January. Most short candidates will be found among the best performers in 2006. The best bullish bet? Think of SOLD. It has driven away some 30,000 realtors who expected the same la dolce vitta that the average realtor is accustomed to, which, obviously, was not SOLD's intention. The good news is that there are still realtors out there unscrupulous enough to successfully exploit the constituency of morons which SOLD continues to provide in ever-increasing quantities. And since the supply of morons in this country is inexhaustible, it is a safe bet that those less scrupulous realtors who can work with inferior leads will eventually stay with SOLD and make it far richer than the market seems to expect at the moment. Look for the stock to double in 12 months.
Dividend-payigng stocks have been the latest fashion de jour as homeowners decided to repeat the trick that had worked so well with houses. With real interest exprences standing at around 5-6%, and some stocks offering similar yields, of course they gladly bought such stocks on margin, waiting for them to appreciate so they can borrow more money against equity, buy more stocks, get even more equity, buy more stocks, ad infinitum. The problem is that dividends cannot be increased as easily as rents, so this feast should end rather sooner than later. Most of these stocks are at their annual highs, and their yields are already below the margin interest expence. In the next 6 months, these profits will be locked and redirected back to the housing market. Look forward to buy some cheap dividend-payers in the summer. Short-term bullish candidates: none.
Housing stocks have rebounded nicely off their lows, and the story will only keep getting better. This is surely the most lucrative part of the market at the moment.
The housing market is about to establish new heights in 2007. Last year, dollar warries caused the Fed to raise rates, temporarily suspending its contract sociale with homeowners, who did not get the promiced 10% annual appreciation. This year, homeowners will again ask for the 10% that was due to them, and this time the Fed will listen. With M3 growing 10% a year, the new liquidity will find its way to the real estate market, once again making 70% of the population that owns houses richer at the expense of the remaining 30%. However, ordinary REITs will fail to capitalize on this trend, becuause they specialize in commercial real estate or in running apartment communities. Both activities are usually done so inefficiently that buying houses and condos is a far better idea than buying such REITs. Mortgage REITs that offer 10% dividend income is the only REIT category worth buying today. Especially lucrative are those REITs that specialize in providing subprime mortgages. As I pointed out on many previous occasions, there is nothing safer than writing an insured mortgage loan with down payment to a homeless beggar on the streat as long as the house serves as a collateral. With house values about to grow another 10% this year, there will be no defaults and no foreclosures whatsoever. REITs like NEW will become the next Altria when the market realizes its error.
Blue chips should drift down gradually, as all the good news are already priced in. In general, Buffett-like investments will perform poorly this year (hint: don't rush to buy RRK-A). Success will come from less obvious strategies. In particular, the much-discredited, but still very much viable growth investment will make a comeback. Here is an opportunity to load up on IRBT, GOOG, and even ISRG.
Health care stocks will continue to do well in 2007. Hospitals will find new, better ways to keep patients sick for longer periods of time, and HMOs will find better ways to charge patients more for this service. The intelligent investor will short all companies that try to sell cheap and efficient medical equipment to hospitals, which they don't need, and long companies that help hospitals count their money more efficiently, which they do need. Hence my long call on QSII - a company that, at forward PE of 25, is quite cheap becuase its products - software that helps hospitals figure out what exactly they did and how much they should charge for it - will always be in high and ever-increasing demand. I make one exception for ISRG. Surely, hospitals couldn't care less whether ISRG's robots help patients or not, but in order to justify further cost increases, they WILL want to purchase just one big-ticket, highly-publicized item, and a da Vinci robotic arm fits the billl ideally. Hospitals and HMOs should continue to reward the long-term investors, but we might yet get a nice case of market panic before the election of Hillary. I would ignore HMOs for now. If I'm right, I'll get a nice 20-30% discount sometime before the election.
The macroeconomic environment will remain stable, and the hard landing talk disappear when people realize that there is no housing bubble. Two major macroeconomic trends will shape this coming year: the resumption of the housing rally, and the influx of foreign capital seeking to diversify into the still-relatively-cheap American assets. With the current exchange rate, it makes perfect sense for people in both Eastern and Western Europe to sell their extra stocks and houses and buy American ones. This, together with the coming inevitable increase of tensions with Russia and China, will be enough to disappoint subscribers to Global Gains who think that international stocks are cheaper than ours. They are not.
To summarize, profits will be made in 2007 on timely shorts, purchases of put options, as well as stocks of builders, mortgage REITs, oil-service companies, and a cleverly selected basket of health care and growth stocks. In any case, it will be a harder challenge than most people currently expect. The easiest money has been made from Aug to Dec. We shall see periods of irrational exhuberance that will try the patience of the most patient shorts, and also some extended periods of underperformance by the stocks I just mentioned. However, I expect both groups of investors to be vindicated by the end of the year.