Stocks: What return to expect in 2007

NEW YORK (Money) -- This has certainly been an anxious year for investors, but the final results haven't been bad at all. Blue chips, in particular, have turned in impressive results.

Over the past year, the Dow Jones industrial average has gained more than 15 percent, several percentage points above the historical average annual return.

The Nasdaq, by contrast, has gained 9 percent. That's not bad, although it isn't as strong as the Dow.

In 2007, the anxiety will certainly persist. Given Iraq and Iran, the Middle East will remain a high-risk place. The worst may be past for oil prices, but it's too soon to know for sure. And political division in Washington will ensure that no coherent economic policy develops.

But stock prices reflect market issues much more than global political issues, unless something absolutely dire is going on in the world. So the key to gauging the market's prospects depends on looking at the economy and the current valuation of stocks.

Before you start, though, it's worth reminding yourself of the variability of returns.

Historically, the S&P 500 has returned an average of about 11.5 percent a year, including dividends. But that figure can vary enormously - even more than you may think - over the short term.

Sixty percent of the time, returns over a single year will be between minus 6 percent and plus 31 percent. That means that a significant amount of the time, returns will be unexpected - really spectacular or so bad that you have to start worrying.

What's more, there's no possible way to predict such extremes. The best you can do is make some educated estimates.

The economy has several things going for it. Inflation remains low, up only 2 percent over the past year. Interest rates are more likely to come down than go up. Unemployment is low at 4.5 percent.

The consensus forecast for economic growth predicts a mild slowdown in 2007 to 2.2 percent followed by a recovery in 2008 to an above-average 3.2 percent.

The alternative negative view is that a continued drop in home prices and commercial property values will precipitate a recession, causing a bear market.

The odds, in my view, are strongly on the side of the positive scenario. The only shock that seems realistic to me would be political - atomic warfare, terrorism or some sort of oil crisis.

I don't see how home prices could decline enough to cause a recession. And deflation in real estate prices will have the positive effect of helping to keep inflation down.

Still, it would be presumptuous to ignore the risks in 2007. So the smart thing to do is look to the long-term.

Variability in returns is much smaller over long stretches of time. For 10-year periods, typical compound annual returns range between 6.6 percent and 16.5 percent. Annualized 20-year returns are 7.8 percent to 14.7 percent.

There are exceptional periods when average returns fall outside these bands. But basically, you can expect to beat most other prudent investments, including high-quality fixed-income choices, if you hold good quality stocks for 20 years or longer.

The biggest opportunity to enhance your returns lies in being a smart stock buyer. You can reduce your risk without cutting into your expected returns if you look for high-quality shares that yield more than 2 percent.

You can boost your long-term gains if you favor stock groups that are undervalued by historical measures. If you buy in a sector that is currently 15 percent or 20 percent below its historical benchmarks and those shares get back to normal sometime in the next 20 years, you will have raised your average return by more than a percentage point a year. Compounded over a long period of time that will make an enormous difference in your eventual wealth.

Blue chips, in general, are slightly undervalued by historical standards. And those with above-average growth rates are still at discounts as large as 22 percent.

In short, the Sivy 70 includes a number of stocks that are compelling buying opportunities as well as some high-yielders that will help hold down risk in a portfolio.

Friday was the winter solstice, the shortest day of the year. From here on, the days get longer and the sun rises higher. My bet is that the same is true for the stock market.

And for those readers who are celebrating more than the solstice, Merry Christmas and Happy Hanukkah. Michael Sivy

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