The winds are shifting in favor of large, blue-chip companies. By Andrew Tanzer, Senior Associate Editor December 31, 2006 As 2007 dawns, some shadows have fallen across the U.S. economy. Air is hissing out of the inflated housing market. Growth in corporate earnings is slowing from a sprint to a trot. The Federal Reserve, still worried about rising inflation, is reluctant to cut interest rates. Yet we remain upbeat about the stock market's prospects in 2007. Based on our economic forecasts and absent an unexpected shock (see Wild Cards), Standard Poor's 500-stock index should return 7% to 12% in the coming year -- and perhaps more.Flush with record profits, businesses will spend briskly. Robust capital expenditures will offset weaker consumer spending and help prevent the economy from sinking into recession. Easing inflation should permit the Fed to start trimming interest rates by mid or late 2007. RELATED STORIES Eight Stocks to Own in 2007 The Three Best International Funds Investing Wild Cards for 2007 Can REITs Keep Surging? Long-term bonds seem stuck in the 4.5% to 5% range, making them unattractive relative to stocks. Compare bond yields with the stock market's earnings yield (the inverse of the market's price-earnings ratio and essentially what the market would yield if it paid out all profits as dividends). Based on 2007 projections, the SP 500 sells at 14 times earnings, so the earnings yield for stocks is about 7%, well above the yield of Treasury bonds. Moreover, history teaches that the market cheers when the Fed starts cutting rates. For example, during a similar slowdown in the middle of an economic expansion in the mid 1990s, stocks surged after the Fed went to work, despite slowing growth in earnings. A combination of moderating inflation, falling interest rates and a soft economic landing are normally a recipe for expanding P/Es. That is why stock-market gains in 2007 could easily exceed 10%, even if profits rise only 7% or so. Advertisement Political factors Another bullish element for stock investors is the presidential cycle. Historically, the third year of a President's term is an excellent one for stocks. Since 1945, the SP has gained an average of 18% in third years, compared with an average of 9% in all years, says SP strategist Sam Stovall. "The market anticipates that a President will try to get his party reelected by putting money into voters' hands," he says. A complicating factor, however, is the capture of both houses of Congress by the Democrats. That means Democrats will set the congressional agenda for at least the next two years. It also means two years of divided government. Investors do not like political uncertainty, but they may not be perturbed by the idea of stalemate: a Congress controlled by Democrats balanced by a Republican President. The more economically populist Democrats will scrutinize drug prices and take a harder -- and perhaps protectionist -- line on this country's mammoth trade deficits, especially the politically sensitive gap with China. The next Congress will almost certainly try to boost the federally mandated minimum wage, pegged at $5.15 an hour for the past ten years. That could hurt fast-food chains, retailers and other service-industry companies that typically pay low wages. On the other hand, more than half of the states and the District of Columbia have already set a minimum wage that's higher than the current federal floor, so any congressionally mandated boost might not depress restaurant and retail stocks. Indeed, shares of McDonald's (symbol MCD) were above their Election Day close within two days. Advertisement The congressional realignment is a mixed bag for publicly traded companies that once had (or still have) ties to the government. Democrats are considered to be sympathetic to Fannie Mae (FNM) and Freddie Mac (FRE). They're less likely than Republicans to tighten regulation of the mortgage packagers and limit the amount of mortgage securities they can hold. Democrats, on the other hand, want to slash the interest rate on student loans, which the Republican-controlled Congress raised in 2006. That could hurt student lender SLM (SLM), better known by its nickname, Sallie Mae (see Students' Pain, Sallie's Gain, Dec.). The coming year will be one for dialing down risk. From 2003 until mid 2006, investors loaded up on risky assets, such as small-company and emerging-market stocks and commodities. That's typical early in an economic cycle, when there's abundant liquidity. But in the autumn of the current economic cycle, the pendulum is swinging the other way. Between the middle of May and the middle of November, the large-company-oriented SP outpaced the small-company Russell 2000 index by about seven percentage points. The bluest of the blue chips can continue to grow, pay out dividends and expand overseas even in an economic slowdown. "Some of the best businesses in the world are selling at very attractive valuations," says Alex Motola, manager of Thornburg Core Growth. He likes such high-quality names in high tech as Microsoft (MSFT) and Apple Computer (AAPL). Wade Pierson, 36, agrees with this line of thinking. Pierson, owner of an executive-search firm in Medford, N.J., began purging his portfolio in the middle of 2006 of volatile small-company stocks, such as Taser International. And out went emerging-markets stocks from Brazil and Mexico. Advertisement Instead, he and his wife, Melissa, also 36, have been loading up on large, consistent growers, such as General Electric, Microsoft, Citigroup and Altria. "Large, stable blue chips have been undervalued for the past few years," says Pierson, who especially likes dividend-payers. "I think that over the next year or two these traditional highfliers are due for a comeback." When the economy slows, investors tend to gravitate to bigger, safer names -- companies less tied to the ups and downs of the economy. "Consumer staples are a great place to hang out when you're worried," says Wendell Perkins, manager of JohnsonFamily Large Cap Value. A.G. Edwards strategist Stuart Freeman recommends companies with rock-solid balance sheets and consistent growth, such as PepsiCo (PEP), Walgreen (WAG) and Sysco (SYY), the food distributor. Case for health care Health care also fares well in a slow-growth economy because patients continue to take their medicine and go to the doctor. This sector also has demographics on its side, which is why Doug Ober, manager of Adams Express, a closed-end fund, favors companies that make medical devices, such as Johnson Johnson (JNJ), Medtronic (MDT) and Zimmer Holdings (ZMH). Pharmaceutical stocks, generally volatile around election time, are more complicated. Pfizer (PFE), Merck (MRK) and Wyeth (WYE) all fell 6% in the three trading days following the election. The Democrats will probably push for legislation to repeal a clause in the Medicare drug-benefit law that prevents the government from negotiating drug prices directly with big pharmaceutical companies. This theoretically could lead to lower prices for drugs and lower profits for manufacturers. But President Bush is likely to veto any bill that is too onerous on drug makers, so any additional weakness in drug stocks should be viewed as buying opportunities. Advertisement You can also play defense in defense. Military spending is driven more by budgets and geopolitics than by the economy, so this hot sector should stay warm in 2007. Rick Helm, manager of Cohen Steers Dividend Value, is fond of General Dynamics (GD) for its defense and aerospace businesses (including Gulfstream jets). Chase Growth's David Scott recommends Lockheed Martin (LMT) and United Technologies (UTX). Of course, increased spending on defense has some potential opposition now in the form of the Democrats, many of whom are pushing for a hastier withdrawal from Iraq. But the Democrats seem to favor higher levels of spending on homeland security, especially at borders and ports. That could benefit such companies as American Science Engineering (ASEI), which makes x-ray and inspection systems, and FLIR Systems (FLIR), maker of thermal-imaging and infrared-camera systems. U.S. corporations, which hold a record $2.4 trillion in cash, will spend lavishly on technology, both hardware and software. Paul Berlinguet, manager of Columbia Large Cap Growth, expects to see solid profit growth at Cisco Systems (CSCO), Oracle (ORCL) and Germany's SAP (SAP), which stand to benefit from corporate spending on information-technology maintenance. Another promising strategy for '07 is to buy shares of U.S. companies that ring up significant sales overseas. Economic growth will be stronger abroad than at home, particularly in emerging markets, and the profitability of U.S. multinationals will benefit from a likely weaker dollar. SP reports that the 500 members of its best-known index generated 41% of sales overseas in 2005, up from 32% in 2000. Duncan Richardson, manager of Eaton Vance Large-Cap Growth, is attracted to Colgate-Palmolive (CL) and Procter Gamble (PG), consumer-products leaders with strong franchises in global markets. Adams Express's Ober notes that AIG (AIG) has a powerful position in the expanding Asian insurance industry and that Schlumberger (SLB) is the premier supplier of services to oil companies around the globe. The china card And how about this for statistical destiny: Vice fund manager Charles Norton estimates that 90% of Las Vegas Sands' revenues will soon flow from Asia, a byproduct of the casino operator hitting the jackpot in Macau and tapping into the Chinese attraction to gambling. Norton also thinks Wall Street has underestimated the import of the Chinese government's decision to permit Altria (MO) to enter the Chinese market, home to 350 million smokers. Finally, a word about volatile commodities, which have taken a breather lately: Theresa Gusman, manager of DWS Commodity Securities, notes that commodity cycles have historically averaged 18 years. We're only five years into this one, she says. Mike Avery, manager of Ivy Asset Strategy, points out that newly prosperous consumers in places such as China and India have worked up hearty appetites for oil and gold, while producers of these resources are struggling to find new deposits. The energy industry will benefit to the degree that solid demand helps prop up oil and gas prices. It will need strong prices because it will have trouble finding friends in the next Congress. The Democrats seem intent on increasing government intervention in energy markets by encouraging greater conservation, adopting more environmentally friendly policies and offering more support for alternative energy. But where should fund investors put their money in 2007? If you accept our basic premise that quality growth stocks are the place to be, try Marsico Growth (MGRIX; 888-860-8686) or T. Rowe Price Growth Stock (PRGFX; 800-638-5660). Reflecting the sluggish performance of big-company growth stocks, both funds returned just 8% annualized over the past five years to November 1. But both beat their peers handily. For a bit more balance from value stocks, we like Vanguard Primecap Core (VPCCX; 800-662-2739). If you seek a value fund paying nice dividends, T. Rowe Price Equity Income (PRFDX), with a five-year annualized return of 10%, makes a fine choice. If you think the sky is falling, consider parking some money in Vice fund (VICEX; 866-264-8783), which invests in the four recession-resistant sectors of tobacco, liquor, gaming and defense. It returned 18% annualized over the past three years. And because commodities add excellent diversification, you might stash 5% of your money in a fund such as iShares GSCI Commodity-Indexed Trust (GSG), an exchange-traded fund.