Rally May Taper Off Later This Year

07/02/2007 12:00 am EST

Focus: MARKETS

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, chief investment strategist for Standard & Poor's, says the US markets may continue to make gains, but they are likely to be limited for the rest of 2007.

Through June 15 of this year, the Standard & Poor's 500 rose 8.1%, all ten sectors were in the black, and 80% of the 130 subindustries gained on the year. In addition, 52 groups recorded double-digit gains, while only three subindustries fell by 10% or more: gold, home building, and motorcycle manufacturers.

This market breadth, strength, and longevity have left analysts scratching their heads and asking, "Why have equity prices strengthened, when fundamental factors have weakened?"

In the past three months, oil prices increased by $10 a barrel, yet stock prices climbed. The forecast for the first Federal Reserve rate cut was delayed to the first quarter of 2008 from the third quarter of 2007, yet stock prices climbed. The yield on the US ten-year Treasury note rose to 5.25% from 4.65%, yet stock prices climbed.

In the past six months, the market appears to have blissfully bypassed events that individually could have triggered a selloff, yet collectively have been treated as nonevents. Are we missing something?

It's possible in the near term, but most likely not in the longer term. Mark Arbeter, S&P's chief technical strategist, says the S&P 500 should be able to make a run at the 1540 to 1560 zone fairly soon. Should the market break above that level, we believe it has a good chance of extending gains into the 1575-1625 area. Arbeter thinks a lot of individual investors are still watching from the sidelines and may regret missing out on this rally, thus extending the time and magnitude of the eventual advance.

Longer term, however, S&P believes the market will not likely be willing to accept additional risks this late in the market and economic cycles, particularly in a period of decelerating earnings growth. As a result, it has maintained its year-end 2007 target for the S&P 500 at 1510, 6.5% above the closing value of 1418 in 2006, and 2% below today's level.

More important than a year-end target, in our opinion, is the appropriate asset allocation. Based on our current view of domestic and foreign equity and fixed income markets, we are suggesting a slight underweighting of US stocks and an overweighting of international equities, as well as an underweighting of an investor's bond portfolio. Specifically, our current allocation calls for 40% in US equities, 25% in foreign stocks, 25% in bonds, and 10% in cash.

Even though US equity prices continue to be supported by M&A activity and share buybacks, we believe foreign equities will be relative outperformers.

We recommend underweighting bonds, as we see the yield on the ten-year Treasury note rising in the next 15 months.

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