Already in '07, There Are Signs the Conventional Wisdom Is Off

So much for the conventional wisdom that last year's strong rally would accelerate in January, a typically strong month in which fresh cash flows into the market. This is the time of year when I like to review the conventional wisdom, since the new year is filled with predictions which often turn out to be wrong. As I've said many times, I'm not blindly contrarian. I respect conventional wisdom because often it's right. But it's hard to make money when everyone agrees on something. It's much more profitable and takes some courage to go against the herd.

I take as my starting point that no one can divine the future, and, thus, predictions are inherently vulnerable to unforeseen events. This year, several themes already have emerged. The U.S. economy will achieve the "soft landing" aimed for by the Fed. The stock market will have a positive, if unspectacular year, gaining about 7% to 8%. Energy and commodity prices will continue to drop as inflation fears abate. Interest rates will remain low, with the Fed likely to be reducing short-term rates by summer. Foreign stocks and especially emerging markets remain attractive. The dollar will continue to fall, though not precipitously, enhancing returns in foreign currencies.

Before returning to these themes, let's consider last year's conventional wisdom, highlighted in my column of a year ago. Then, the conventional wisdom was that U.S. markets were overvalued. I disagreed, arguing that "with profit growth expected to continue, U.S. stocks look like relative bargains." With last year's strong gains in hand, I rest my case. I agreed with the conventional wisdom that emerging markets were undervalued and offered good opportunities, although I urged waiting for a pullback — which came in late spring. I also bucked the conventional wisdom by recommending pharmaceuticals, communications and technology stocks. Communications stocks really came to life, especially the cable companies. Technology and pharmaceutical stocks had decent but unspectacular years, lagging many other sectors. Now the conventional wisdom is that technology will outperform in 2007.

This year, the first week's trading was an indication how much of the conventional wisdom rests on the assumption that the Fed has stopped raising rates, and will likely begin reducing them in 2007. To me, this is the biggest risk for believers in the conventional wisdom for 2007. Higher-than-expected rates could slow or reverse the drop in the dollar, dampening returns for foreign investments. The sharp pullback in emerging markets last year was triggered by rising longer-term interest rates in the U.S. and fears this would dampen the global expansion. My hunch is that a similar scare will afflict markets at some point this year, which will likely represent a buying opportunity. But longer term, I think the conventional wisdom is right. Sooner or later, the Fed will begin to reduce rates, and the conventional wisdom will be vindicated.

So, even though the bull market that began in October 2002 is reaching old age, I, too, am bullish on the U.S. stock market, maybe even a little more so than the conventional wisdom. But not so much as to provide much of a contrarian profit opportunity. The key will be to reduce exposure at overoptimistic market peaks, and take advantage of corrections to buy. That's the standard Common Sense playbook: Buy lower and sell higher. It's an approach that doesn't require any gazing into a crystal ball, and which I'll be pursuing throughout the year.

Once again, I'll take a contrarian view by recommending the health-care sector. Now that the Democrats have control of Congress, it's more out of favor than ever. And yet I continue to believe that sheer demographics will propel these stocks to outperform one of these years. In my view, plans that expand prescription-drug use and still allow a profit to drug manufacturers should compensate in increased volume and revenue for what they cost in lower margins. With rampant pessimism clouding the sector, this strikes me as a good time to invest.

As I did last year, I embrace the conventional wisdom that foreign stocks continue to represent excellent opportunities. But this year I'm shifting away from emerging markets toward the more mature economies of Europe and Japan. Emerging markets have simply risen too far too fast. With Russia and Belarus squabbling over oil deliveries (and the Kremlin exercising increasingly authoritarian control over its oil sector); with Venezuela threatening drastic new nationalization measures; and Thailand roiled by controls on foreign capital, the conventional wisdom that emerging markets will continue to soar this year strikes me as unduly optimistic. Sooner or later, something is going to happen to remind investors that these fledgling economies and political systems are riskier than centuries-old democracies.

Year after year, I've resisted the conventional wisdom that low interest rates are here to stay, and so far I've been wrong. Call me stubborn, but I still believe we could see higher longer-term rates in 2007, which is a distinctly contrarian view. Even if the Fed does begin to cut short-term rates, a stronger economy should increase demand for longer-term borrowing and produce higher longer-term rates, not to mention a "normal" yield curve. At this point the yield curve has been inverted for so long we may need to change our view of "normal." Still, I'm very reluctant to change my belief that the laws of economics eventually assert themselves. Fortunately, my strategy for the possibility of higher longer-term rates — parking my fixed income assets in one- to three-year CDs — has stood me in good stead, with yields now at about 5%. But one of these years I'd like to be able to extend some maturities at higher rates. We'll see if 2007 delivers such an opportunity.

So on with the new year. One thing I've learned is that whether the conventional wisdom proves right or wrong, there will still be opportunities for investors who resist the tide of popular sentiment.