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Friday, December 15, 2006

Economy: Coming in for Landing in 2007

Following the dramaticincreases in short-term interest rates by the Federal Reserve over the pasttwo years and given the current downturn in the domestic housing market,there's not much question as to whether the U.S. economy is slowing down.

The big debate, of course, is whether the country will experience a "hard"landing -- in other words, a recession -- or see the economy merely slow to a modest growth rate and then take off again after a more forgiving "soft" landing.

To help investors get a better handle on the hard versus soft landingdebate, financial services firm A.G. Edwards has just released the 2007 outlook report from its Investment Strategy Committee. Within sight from a wide range of sources, the report combines viewpoints from the firm's market strategists, economists, analysts and portfolio managers to examine the debate and identify the risks and opportunities thecommittee sees in the year ahead.

Chief Economist Gary Thayer notes that over the past five years, the economy has oscillated between extremes -- in recession or struggling out of it from 2001 to 2003 but then showing strength and expanding at anabove- average rate from 2004 through the early part of this year.

The Fed has drained excess liquidity from the economy with its lengthy cycle ofconsecutive rate hikes, and Thayer thinks the most likely scenario at thispoint is a soft landing between these two extremes.

"The Fed does not want the economy to swing between boom and bust," Thayer says, "but that does not mean it could not happen."

In addition to the gradual Fed rate increases, which gave borrowers time to adjust to tighter credit conditions, Thayer points out several other factors that may be indicative of things to come. A sharp drop in energy prices in the second half of this year, a halt in the Fed rate hikes once the housing market weakness became pronounced and continued growth incorporate profits have all helped offset other problems and seem to be setting the stage for a soft landing.

Turning attention to the stock market, Chief Market Strategist Al Goldman enumerates some of the pressing issues that could possibly turn into stumbling blocks for the soft landing scenario. He says the areas of greatest concern are geopolitical, as Iraq, Iran and North Korea will likely remain very serious problems. But Goldman takes heart in the trends that are currently in place in the economy and says recent history bodes well for the near-term market outlook.

"Economic activity has slowed primarily because of the recession in the building industry," Goldman says. "However, the economic trends in place indicate a slowdown rather than a meltdown, and thus, we look for a soft landing in 2007."

Goldman notes that the rising market is now 49 months old, compared with the average duration of 25 months for previous bull markets. But healso points out that the current market's advance has been more laboredthan most, and a couple of years of lackluster growth in the middle havehelped increase its longevity. Goldman is looking for an increase in S&P500 earnings on the order of about seven percent over 2006 earnings, which would predict a target for the S&P of approximately 1472 in late 2007.

To give investors a clearer picture of where they should focus their investment dollars, Chief Equity Strategist Stuart Freeman offers several sector picks for the new year.

"Based on our expectations for a slower growth economic environmentduring the first half of 2007, we continue to suggest investors overweight the defensive health care and consumer staples sectors," Freeman says. "However, because more cyclical stocks have already retrenched during the course of the year, our industry group rankings include a larger mix of more cyclical stocks than they did six months ago."

Some examples of Freeman's most favored individual industry groups include: energy companies (except the major integrated international names), agricultural products, construction & engineering, health care distributors, building products, water utilities, steel, managed healthcare, household appliances, and reinsurance companies.

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