What to expect in 2007!

Pandemonium – that’s how I’d describe Christmas time at my house this year! Last minute trips to the mall … marathon present-wrapping sessions … dogs barking . and lots of cameras flashing.

Just like the markets in 2006. Whether you’re talking about the carnage in the housing sector, the roller coaster ride in stocks, or the wild swings in interest rates, this year was anything but boring.

And if I’m right, 2007 could be even crazier. So, today, I’d like to look back at some of the major developments of the past year, and tell you what to expect in the year ahead.

Housing Takes a Header; A Major
Disappointment Looms in 2007

If there’s any one trend that dominated the markets and the economy in 2006, it was the bursting of the housing bubble. Starry-eyed optimists started off the year claiming we were due for nothing more than a nice, gentle soft landing.

But I warned you that things would be different … much different! In my report of almost 11 months ago to the day, I told you:

“Investors are dumping condos and homes bought in last year’s frenzy. Homeowners are also rushing to sell. Nearly every month, the number of new and existing unsold homes is growing to new all-time highs.”

December home sales missed Wall Street’s expectations by a country mile. And the condo market was coming apart at the seams, with sales volumes falling fast and for-sale inventory surging about 66% from a year earlier.

By early spring, the writing was on the wall. Existing home sales had dropped to their lowest level in almost two years. The supply of new homes on the market had surged to an all-time U.S. record. And the condo market had gone from bad to worse.

By October, we began seeing a new phase in the housing decline – one marked by the biggest new and existing home price declines in U.S. history. You were prepared though. After all, I spelled out seven ways to protect yourself and potentially profit from the unfolding bust.

So what’s in store for housing in the coming year? More disappointment, I’m afraid.

The problem is that we’re still swimming in inventory. The supply of new homes for sale shot up about 96% from its 2001 low through the July 2006 peak. It’s still hovering close to that level now. As for existing homes, the supply there more than doubled between early 2001 and this past July. Since then, we’ve only managed to work through a tiny portion of those 3.86 million units.

Meanwhile, demand for housing remains weak. The speculators that drove the market in the latter part of the boom are gone. And even after the recent price decline, houses are still generally unaffordable. They’re substantially overvalued in terms of common measures like median incomes and rental rates.

Eventually, supply and demand will get back in balance. But I don’t think that’ll happen until at least 2008.

Interest Rates See-Sawing Amid
Fed Foibles and Economic Uncertainty

Unlike housing, which basically headed south in a straight line, short-term interest rates rose during the first part of the year, and then hovered for the rest of the year. That’s because the Federal Reserve Board hiked rates 17 straight times in a row, culminating with a final quarter of a percentage point move in late June.

Long-term interest rates were an entirely different story, though. Ten-year Treasury yields started the year way down around 4.3% … climbed as high as 5.25% in June … then spent the rest of the year falling again. They’re on track to finish 2006 near 4.7%.

One of the factors that helped suppress long-term rates was the flood of foreign money into the U.S. But that’s a double-edged sword because all that money from overseas pension funds, central banks, and private asset managers could just as easily flow right back out. In my opinion, this is a major risk, and Wall Street is underestimating it.

My forecast for 2007? More volatility. If the housing market continues to slump, as I expect it to, there’s a decent chance the Fed will panic. Remember, these guys are the worldwide champions of easy money – they throw cash at any financial problem that comes along. I don’t expect things to be any different in the New Year.

But, as you’ve heard in Money and Markets so many times before, the Fed only has direct control over short-term interest rates. So don’t be surprised to see long-term interest rates start heading higher again even if the Fed cuts. Before 2007 is over, 10-year Treasuries just might be yielding more than 5% … or even 5.5%.

Why Risk Is Not Dead

If there’s one last trend that stood out in 2006, it was the complete abandonment of fear.

Sure, we had some tremors in the middle of the year, which preceded a big decline in the Dow. But by late July, investors had completely shrugged off any worries about the stock market drop. Ditto for the plunge in the U.S. dollar.

By the last few days of this year, the Dow had shot up more than 1,500 points and the VIX index, which falls when investor are complacent, had collapsed to its lowest level in more than a decade.

On the economic front, soothing “soft landing” talk enveloped stock traders like a warm blanket. They increasingly bet on a scenario like 1994-95, when a Fed tightening cycle slowed the economy but didn’t crush it. This optimism is what sparked the gigantic rally in stocks.

I continue to focus on the potential risks being ignored by Wall Street – like looming credit problems and risks in the bond market. And despite the stock market’s recent strength, I refuse to throw caution to the wind.

In fact, I think 2007 will be the year risk returns – in many forms. The problems in housing, mortgages, and junk bonds could explode onto the front pages by the middle of the year. That, in turn, could rattle U.S. stock markets, which are priced for perfection. Look for a sharp decline out of the blue, and some real problems in the high-risk portion of the bond market.

I’m not saying you should sell everything and stick your money under a mattress. However, 2007 might be a good time to stick to the highest-quality stocks … the most solid foreign shares … and some of the exchange-traded funds we’ve been telling you about.

Have a happy and healthy New Year’s holiday, and I’ll talk to you in 2007!

Until next time,

Mike

P.S. If you want more information on what 2007 has in store for investors, subscribe to Safe Money Report. In our gala 2007 forecast issue, which goes to press next week, Martin and I will give you our best ideas on how to profit from the unfolding trends I just talked about.

About MONEY AND MARKETS

MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Wendy Montes de Oca, Kristen Adams, Jennifer Moran, Red Morgan, and Julie Trudeau.

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