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Markets: Market Speak
New York: December 27, 2006
By John R. Stephenson

So, what is the stock market trying to tell us? Are the markets going to soar in 2007, or will the weight of rapidly deflating house prices be too much for the markets to handle? The stock market is nothing but a big expectations machine, with the expected future value of stocks being baked into the current pricing levels of the market. For many, the direction of stock markets is the best predictor there is of the direction not only of stocks but also of the economy in the years ahead. Given the highs that stock markets have traded at lately, 2007 looks pretty darn good. Investors seem to be saying, "don't worry, be happy" as markets continue to finish 2006 in strength.

One obvious example of the expected future strength of North American stock markets is the performance of the technology-weighted NASDAQ stock exchange. The NASDAQ is one of the most cyclical of all the major stock markets since the valuations of technology companies are largely influenced by the spending patterns of corporate America. Not only has price performance been strong on the NASDAQ this year, but this has also been a year where technology companies have been under fire for the backdating of stock options. In spite of all the problems surrounding technology companies this year, the NASDAQ has continued to post impressive gains.

Figure 1: NASDAQ Stock Index

Source: PC Quote

But it isn't just the NASDAQ that has continued to soar, stock markets all around the world seem to be marching higher. Emerging markets have been particularly strong with the last quarter of 2006 witnessing the lowest bond spreads to U.S. treasuries ever recorded. With a wall of capital hitting the world's financial markets, the up trend for securities of all stripes has only intensified. Asian currencies, such as the Thai Baht, have soared recently as speculators and investors alike have been grabbing all the securities they can carry from emerging Asia. Even the U.S. dollar has rallied of late.

The biggest risk for financial markets in 2007 appears to be that markets don't perceive that there is risk in the markets. For example, the shares of emerging market corporations are priced as if they were companies operating for many decades in the developed world. Risk, is just not being priced into the market. Here at home, the problems keep on coming, yet the stock market seems oblivious. With economic growth in the U.S. clocking in at a meager 2 percent this quarter, an inverted yield curve (short term interest rates above long-term rates), isn't the optimism in the markets a little unwarranted? Yes, but for the foreseeable future, markets are likely to go up.

Until they don't. Just when the eventual crack will happen and what form it will take remains a mystery. For my money, it will likely come in the form of a devaluation of the U.S. dollar and a subsequent crisis of confidence. Another alternative? The market will once again start to see the risks inherent in our foreign oil dependence and OPEC will once again become irrelevant as a price setter as concerns over Iran, Iraq, Nigeria or Russia take center stage in the minds of investors.

But until the market cracks, it will continue to go up. The reason? The stock market is already signaling to investors that it is heading higher because of the strength in which stock markets have exited the year.

When the stock market cracks and begins to tumble, another huge opportunity will exist for investors to consolidate their holdings in the key base metal and oil sands stocks which are likely to be the investment winners in future years. So far, the markets appear sanguine, but there are some signs that we are starting to top out in terms of short-term performance. Savvy real estate investors such as Sam Zell are selling properties and insiders are dumping shares — surely a sign that the top has occurred, at least in certain sectors of the economy or stock market.

For investors concerned about a pullback in equity prices, there are a couple of things to consider. For starters, a portfolio weighted toward great dividend paying stocks is one way to reduce portfolio risk. Another is to consider purchasing the shares of gold miners or better yet the "GLD" a gold exchange traded fund ("ETF") which should mitigate any downside if the U.S. dollar begins to weaken. Long-dated zero coupon bonds is another way for investors to profit if things begin to take a tumble and interest rates start to fall.

If the markets do move down, an opportunity to buy resource stocks for the second bull market in commodities will occur. This new bull market will be driven, not by surging commodity prices, but by expansion of the multiples (e.g. price/earnings multiples) of these stocks. Great quality stocks that are levered to the Canadian oil sands and base metals will benefit from a scarcity premium, as their assets are assets that can't be replicated at any cost. Investors, looking to benefit over the coming year, should position their portfolios for great defense by buying long-dated zero coupon bonds, gold stocks and blue chip dividend paying stocks while, at the same time, buying the best names in the resource sector on pullbacks.
StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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