E + I + E + I = O: The Barnyard Forecast - 2007

Our Barnyard Forecast for 2006 was very close to the mark on much of the year's actual results. Our two key predictions were that 10-year T-bonds would rise in yield but end the year below 5% and that stocks would end the year between 12,000 and 13,000. We correctly described the trends of both economic growth and inflation. As we said in our recent client letter, it could have just been luck, or that our models were dialed in pretty well. To find out what our models are saying about the coming year, we are sharing a condensed version our 2007 Barnyard Forecast.

E+I+ E+ I=O is taken from the acronym of the financial data we analyze: Economy, Inflation, Earnings, Interest, and Opportunities for stocks.

The Economy will weaken in the coming year to near 2.5% GDP growth with the primary reason being that the Fed will cut rates later rather than sooner. That will not harm stocks, significantly, because the weakening economy, ultimately, will help slow inflation and permit the Fed to cut rates, which will be a positive for stocks. We rate the economy positive for stocks. Inflation is improving, but the Core CPI rate is still a bit too high. We do not view this as a problem in the long run, but it may create some headwinds for stocks in the short run. The weak Housing market can solve a lot of this problem, and we believe Core CPI will end the year under 2%. Inflation is neutral for stocks. Earnings are very strong, and we see few signs that they will slow by much in the coming year. We estimate that S&P 500 and Dow Jones 30 earnings will both grow near 10%. We rate earnings as positive for stocks. We rate Interest Rates as neutral for stocks. Even though the Fed has stopped raising rates, as we said earlier, Core CPI is too high and we think that will keep the Fed on the sidelines longer than many analysts are predicting. We believe Fed Funds and 10-year Treasuries, however, will end the year under 5%. That gives a total of two positive scores and two neutral scores. On a balance, that produces a positive rating for stocks in the year to come. One of our most reliable stock market valuation models, our Dividend Valuation Model, has a fair market estimate for the Dow Jones 30 of close to 14,000. That sounds like a pretty good number from all that we see.