This will be a year of unprecedented volatility and opportunity for equity markets. Everything that can happen will happen and traders must be prepared for the worst of times and hope for the best.
The wars in Iraq and Afghanistan will continue through the rest of the year with images of death and destruction appearing nightly on television. The likelihood of the Iraq war spreading into a regional conflict with Iran or Syria is real. North Korea is still a constant threat to its neighbors whom we have promised to aid if attacked. The threat of a terrorist attack on U.S. soil is still present. Then there are threats that will cause us to rewrite the book on threats to be considered.
The U.S. consumer is overleveraged, housing prices have fallen and the U.S. account deficit still is growing. We are in the beginning of a presidential election cycle and commodity prices are volatile. More evidence shows global warming is real. The threat of an outbreak of some new plague or pestilence could be a plane ride away. The reason to take heed of these realities, but not fear them, is that we are part of a global economy and what happens on one side of the planet could affect our markets.
In spite of all this, the outlook for the remainder of 2007 in equities is positive. That’s right, the investor who has the stomach and wisdom to prepare for the challenges that will come will have an opportunity to prosper.
Preparing for and reacting to fundamental events will rule the day. This does not mean the technicals are to be ignored, but that is a different discussion. The equities markets have been moving higher and the trend has been your friend (see “Stick with a winner,” below).
The stock market is at an all-time high as of this writing, in spite of conflicting technical and fundamental data. The long term Dow Jones Industrial Average chart is a good illustration of why dollar cost averaging is such a good investment tool. For the time frame we’re looking at, which is the remainder of this year, don’t put your trust in anything that is subject to change. That means everything from company earnings, to the weather forecast, to chart formations to economic theory will be challenged this year. Short term volatility will present opportunities for traders who can take advantage of market swings.
Yet technical and fundamental indicators are as far as most average investors will bother to look. That is not to say that the institutional trader will not face challenges too. What happens when the model that is being used, based on some valid theory or algorithm, fails? The keys to success will be keeping it simple — taking what the markets give you and not trying to impose your will on the market.
The year 2007 could mark the end of an up cycle in the equity markets for some time. A day of reckoning is coming for the United States that will pull the equities markets down. Unfunded social security obligations, rising health care costs and ballooning trade deficits will begin to crack the foundation of our economy. The sectors that were supposed to be able to thrive in a down economy will falter.
There is nothing new under the sun, so for the trader to balance risk and reward there are five keys that should be considered: Invest for the long term, diversify, don’t get caught up in the hype, apply dollar cost averaging and make sure you have commodity exposure.
There will be bright spots for companies that are run efficiently, and that should return a dividend to their stockholders. Then there will be companies that are in the right place at the right time to take advantage of a trend or innovation that takes off.
LEADING SECTORS
Technology, commodities and the emerging economies sectors will be the leaders this year. As “Rebounding tech” (below) shows, the Nasdaq has posted steady growth. New technologies and innovations will create success stories. Traders willing to do their homework to find the sectors that will drive technology will be rewarded. Consider medicine, manufacturing, electronics and software as areas of opportunity. The next few years could yield some of the greatest technological breakthroughs in our lifetime.
There will continue to be a transfer of wealth and a creation of wealth in the world. Those who have will get more and those who do not have will struggle to stay above water. We also are beginning to see the emergence of the entrepreneur. The flow of wealth will go both ways. For example, 10 years ago China was rich in culture and history but was weak economically. Today it is on the verge of rivaling the United States as an economic power. There has been more wealth created there in the past 10 years than in the history of China and it is just getting started.
What that means for the equity markets is that companies that participate in the emerging economies around the world can prosper (see “Leap and bounds,” below).
We know that the gap between the rich and poor is getting wider and the middle is being squeezed. The question is how to profit from this fact. Play both ends of the spectrum. Market sectors that provide services or products to either end of the spectrum will be positioned to do well.
Finally, perceptions drive consumer confidence. How this all plays out will be the deciding factor in how the equity markets perform this year. If the perception is that the country and economy are not going in the right direction, regardless of the data, there will be a pullback from the consumer, who has held up the economy to this point.
“It’s the consumer, stupid” (below) illustrates that consumer confidence is the key to continued economic growth. If the consumer becomes negative on the direction of the country, markets will be in trouble. With the presidential election ahead, little positive news will be coming forth. Wage inequality is becoming a big issue, not just from a public relations perspective for CEOs, but also for day-to-day working-class men and women. If the perception is that “no matter how hard you work, you will struggle to pay your bills or save for college or retirement,” consumer confidence will suffer and people will spend less.
Responding to events that affect the markets must not be done in a panic. Take into account the gravity of the situation and ponder the fall out from as many angles as possible. For example, has an event like this occurred before and if so what was the markets reaction? How are foreign markets responding? Listen to the news for the headlines, then turn off the volume. Lastly measure your reaction against your trading plan. Does it fit into your discipline?
So what does this scenario mean for the next six months? If no land mines appear, the Dow Jones Industrial average will get to 13,000. However, if things get ugly — and many of the pitfalls we discussed earlier come to fruition — the Dow could be back down to 10,000.
My target for the S&P 500 on the up side is 1,500 but on the downside it could go to 1,200. The Nasdaq could go as high as 2,000 while on the down side it could drop to 1,700. The lower targets for the equities are based on a major correction verses the upside target, which takes into account modest continued growth.
The keys to success this year will be to stay disciplined and to be ready to take advantage of what the market gives you.
Larry Young is a 15-year market veteran. He has earned a solid reputation in the futures industry and is frequently quoted in the Wall Street Journal, Bloomberg and other publications. E-mail: l.young@infinitybrokerage.com.
