In my last outlook, written in early November, I stated that the market could achieve new highs over the next several months but that we were close to a top. Indeed, since that time, the S&P500 has rallied a little bit over 3%. I think the top has arrived and am quite cautious near-term. That said, my 12 month outlook has actually improved modestly. I had previously thought that equity returns would be positive in the mid-high single digits range. It now looks like equities could post returns in the low-mid teens range, not unlike those seen in 2006.

The reason I am cautious near-term relates primarily to the high degree of complacency in the market as measured by a number of indicators. Over the last four years there have been four periods of a 5-10% decline in the S&P 500. More than 60% of stocks were within 10% of their 52-week highs at each point prior to respective declines. Currently 62% of S&P 500 stocks are at this level, signaling significant market bullishness. Other indicators of sentiment such as tight credit spreads, a high Rydex Nova/Ursa ratio, and bottoming market volatility also are suggestive of a market top. Lastly, the ratio of insider buying to selling is also at a high which is, again, suggestive of a market top.

My 12 month view is much more positive. The key driver to this view is that I expect interest rates to be lower 12 months from now. While I do not expect the housing market deterioration to drag the U.S. economy into recession, I do expect it to continue to weigh on GDP growth. We are also starting to see the impact on employment which should become more pronounced over the next six months. I think that the Fed will respond by beginning to cut rates in the second half of 2007. This view is predicated on a continued moderation in inflation. If commodity and oil prices rebound materially, labor market tightness persists, and/or the economy demonstrates surprising strength, I will be wrong about the direction of rates. Investor fears, related to the housing market could start to improve over the course of the first half which may improve sentiment. I expect that rate moderation and better sentiment will translate into higher price-earnings ratios. While I believe that profit growth will be more modest in 2007 (7-9%), this deceleration will be more than offset by higher P/Es.

There are several more factors impacting my long view. Despite the fact that central banks have been withdrawing liquidity, global liquidity conditions continue to be healthy. Furthermore, free cash flow yields remain attractive both in the U.S. and abroad while corporate coffers and the pockets of private equity firms remain full. This should drive significant M&A and share repurchases in 2007.

I still favor equities over bonds, but could get more interested in bonds mid-year, assuming I am right about Fed activity in the second half. I continue to be biased toward growth, which still looks cheap visa vie value, and tends to perform better in a slowing economy. In terms of economic sectors, I am more defensively inclined (staples, health care) consistent with my view of slowing growth. I am avoiding more cyclical sectors like industrials and tech notwithstanding an interest in certain industrials (water, clean-tech, rails, ag-related, conglomerates) and tech stocks (those that will benefit from the launch of Microsoft Vista and/or those that have retail appeal). I like energy and commodities based on the strong secular growth story associated with these sectors but would only be buying energy stocks now. I would, however, buy commodity stocks on a pull-back. I am negative near-term on discretionary stocks, but think that they will perform well after a price correction and probably close the year higher. I am generally neutral on other sectors (financials, utilities and telecom). International stocks look better than domestics based on valuation as well as my negative bias on the dollar. I also favor large cap over small cap stocks based primarily on valuation. U.S. real estate looks over valued but international real estate is still an investable theme, particularly in Asia. Lastly, as default rates should remain low, I prefer high yield debt over investment grade debt.

Those of you who know me, know that I am a worrier and there is certainly plenty to worry about in 2007. Global liquidity has been fueled by Asian goods exporting countries and the oil producing countries in the Middle East and Russia. While Asian export trends remain in tact, a significant reduction in oil prices could have an adverse impact on liquidity. Also, I do not believe that the inversion of the U.S. yield curve is forecasting a recession but the risk is a real one. Jonathan Wright’s (Federal Reserve economist) probit recession model, which incorporates a number of variables inclusive of the yield curve, is currently forecasting a recession probability of 78% in the next 12 months. Lastly, it seems to me that geopolitical risks remain high. Potential events in 2007 that could roil markets include: a military confrontation with Iran, further deterioration in Iraq, a break-down in North Korean talks, U.S. military efforts to oust/capture Al Qaeda leadership in Pakistan, and, last but not least, Putin’s succession in Russia.

So in conclusion, it may be a bumpy ride, but I expect that investors that remain with a net-long equity exposure in 2007 will be well rewarded.