By Martin Wolk Executive business editor
msnbc.com
updated 12/28/2006 12:52:45 PM ET 2006-12-28T17:52:45

After a surprising rally that propelled the stock market's best-known indicator to record levels in 2006, analysts are looking for a less spectacular but still solid year in 2007.

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Although the economy is slowing substantially and there are signs that inflation is heating up, the vast majority of forecasters are looking for a "soft landing" scenario that should lead to continued growth and a rising stock market, if not the double-digit returns of the past five months.

"I would use the expression single-digit," said Hugh Johnson, chairman of Johnson Illington Advisors.

"I'm looking for single-digit growth in profits and a single-digit rise in the stock market," he said. "We're late in the cycle, and the economy is slowing and earnings should slow, which is very symptomatic of the late stages of the cycle. The stock market should reflect that by going up at a much more sluggish rate."

Sam Stovall, chief investment strategist for S&P Equity Research, agreed, saying the market is likely to grow solidly but well under the 14 percent return seen for the year to date. For next year, he is projecting the Standard & Poor's 500, a broad measure of big-company stocks, will rise about 8 percent.

"We still think it's going to be pretty good," he said.

Things looked a lot different just a few months ago.

As recently as mid-July, it seemed like another ho-hum year for Wall Street – or worse. As a war raged in Lebanon and tensions rose over Iran's nuclear ambitions, gas and oil prices soared to record levels. The wheels were coming off the housing market, and the economy was slowing after a post-Katrina growth spurt.

As late as July 18, the stock market was in negative territory for the year.

Then Federal Reserve Chairman Ben Bernanke, in office less than six months and still working through a somewhat  uneasy relationship with financial markets, fired the starting gun for a stock market rally that turned out to have surprising legs.

In testimony to Congress that month, Bernanke said rising inflation was a concern but  the central bank also was worried about raising rates too high and squeezing the economy. The comments were seen as a signal that central bankers were close to the end of a cycle in which they raised interest rates 17 straight times over two years.

As it turned out, the Fed already had moved the sidelines. The central bank has not raised rates since June 29, and many analysts think the next move may be to cut rates sometime next year to stimulate the slow-growing economy.

The more favorable rate environment is far from the only factor behind the stock market's vigorous rally. Some other developments have been at work:

  • Strong corporate profits. Even though the economy has been growing only modestly, corporate profits have been going gangbusters, rising at double-digit rates as industries ranging from airlines to telecommunications have reaped the benefits of aggressive cost-cutting.
  • Falling oil prices. Crude oil has fallen from a high of about $79 a barrel in midsummer to well under $65, and prices for refined products have fallen as well. That has cut costs for industry and put cash back into consumer pockets.
  • Reduced geopolitical tensions. Even though the United States and its allies remain mired in the war in Iraq, tensions over Iran have eased slightly, and North Korea recently returned to six-party negotiations.
  • A world awash in cash. Many analysts point to the huge amount of "liquidity" or cash on the balance sheets of individuals and corporations here and abroad, all seeking a home in financial markets. Private hedge funds backed by wealthy individuals and foundations have poured money into the stock market and are behind some of the year's biggest corporate acquisitions, including the $21.3 billion purchase of hospital chain HCA Inc.

The seemingly bottomless appetite of hedge funds is suspected of driving stock prices widely higher in recent weeks, reminding some observers of the go-go days of the 1990s.

"The expectations are that more companies will get bought up or bought out, and the simple arithmetic is that the supply of stocks is going down and the demand for stocks is going up," said Johnson. "What you have to worry about is this will lead to period of speculation when investors  buy companies at prices that are arguably overvalued with the fantasy they will become even more overvalued."

The euphoria could be kept in check by the sobering realization that the economy is growing at a sluggish 2 percent rate instead of the 3.5 percent rate of recent years. That slowdown is likely to mean that corporate profits will not continue to race ahead the way they have over the past year.

"I would not be surprised to see the market move sideways as the economy goes through this soft patch over the next six to nine months," said Nariman Behravash, chief economist for Global Insight, a consulting firm. "The market is not going to take a hit but also certainly is not going to see the kind of gains we have seen lately, which have been pretty good."

And all these relatively optimistic forecasts assume the economy merely slows and does not turn down into a recession. Behravesh, for example, expects the Fed to cut interest rates beginning sometime in mid-2007 to prevent the economy from slowing too much.

Others worry that it may be too late and that the economy will slip into recession next year.

"All the good news is starting to be priced into the market," said Brad Sorensen, director of sector research for Charles Schwab. "We're certainly not discussing the possibility of a soft landing, but we're not quite as confident as much of the market seems to be."

He says he sees a 50-50 chance that the housing downturn worsens and drags the economy into at least a mild recession. Other analysts fear some kind of geopolitical event that could drive oil prices back above $70 a barrel, or even above $90.

But Stovall, of Standard and Poor's, said investors can take some comfort in past history, which shows that since World War II the stock market has invariably risen in the third year of a presidential term, and usually at a higher-than-average rate. The theory is that the party in power gives the economy a push ahead of a presidential year, even during times of a divided government.

On average the S&P 500 has risen 18 percent in the third year of a president's term, compared with an average 9 percent for all years from 1945 to 2006.

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