Can things get much better for investors in U.S. market? In the four years since the end of the tech crash, the U.S. market has gained 59%. This has sent many indices, including the Dow Jones industrial average, to new highs.

A telling statistic is growth of corporate earnings, which are now at a historical high of 13% of national income. In 1982, the year the great bull market began to soar, they were 7%.

This new year, however, opens with the U.S. market facing many obstacles. U.S. economic growth is slowing. The annualized increase in gross domestic product dropped to 2.2% in the third quarter of 2006 from a high of 5.6% in the first quarter.

A crucial factor is housing. The U.S. has just had one of its biggest housing booms, which created the majority of jobs in recent years, as well as providing a piggy bank that enabled consumers to borrow hundreds of billions of dollars from their increased home equity to fund consumer spending. But sales and construction are now dropping.

As well, inflation, the rapid increase in short-term interest rates over the past few years, government deficits and weakness in the U.S. dollar add to concerns. But it is consumer spending, the largest item in the economy, that will determine how strong the U.S. economy will be in 2007, or how weak.

Housing, then, is the immediate crisis. Home equity may drop sharply as demand falls away. Should the drop in housing sales intensify, the drop in prices will become acute. That will undermine consumer spending in the U.S. as well as industries that depend on construction — everything from building-supply retailers to household appliance manufacturing.

Also at risk are U.S. banks and other mortgage lenders, who increasingly cut credit standards during the past few years, creating a boom in subprime lending and in structured mortgages that offer interest-only or low-interest loans. In the case of the latter, higher market interest rates are triggering higher monthly payments.

Historically, housing prices gain in step with GDP. But in the recent boom, prices moved far higher than GDP growth. For housing prices to revert to their historical trend, a 44% price drop is implied.

Increased risk in the housing sector is only one aspect of the increase in risk in financial markets. A byproduct of the private equity boom is debt creation. The usual first step after a takeover is for the purchased business to borrow as heavily as the markets will allow. The cash is then siphoned off to the purchaser as a dividend, leaving behind a business that will be crippled in a slowdown.

There are also signs of more defaults in unsecured credit card debt.

Recommendations from independent analysts reflect a cautious view of 2007. In Standard & Poor’s Outlook, only industrials and financials have an overweighted portfolio position.

The Value Line Investment Survey has lowered the average gain it expects in the next three to five years for the 1,700 stocks it analyses to 35% from 45%. Value Line’s record shows its forecasts tend to be about 45% higher than what occurs, so this estimate suggests a 10% drop in stock prices in the next three to five years.

Of the 10 sectors into which Standard & Poor’s 500 composite index is divided, five — consumer staples, energy, financials, industrials and materials — are at record highs on a monthly closing basis.

Here is what analysts expect:

> Energy. Crude oil and natural gas prices will set the direction for this sector. Prices are expected to be higher than in the last few months of 2006, although not at the peak levels of 2006. (All prices in this story are in US$.)

Not all will be buoyant in this sector. Cost pressures may erode oil and gas services firms.

The major energy stock that is viewed as underpriced is Conoco-Phillips, an integrated producer trading at $67 a share or about 2.5 times tangible book value. Its anticipated five-year earnings growth is 9% a year. The firm and its predecessors have paid dividends for 72 years.

> Materials. In the U.S., diversified chemicals account for one-quarter of this sector. Value Line rates this industry as one of the 12 “most timely”; basic chemicals are further down the list. “Most timely” means the industry or stock is expected to have high relative price performance in the next year.

@page_break@One stock rated highly by analysts is E.I. du Pont de Nemours & Co., one of the largest chemical producers. Its projected five-year earnings growth is 10% a year. A dividend payer since 1904, du Pont’s current yield is 3%.

The boom in industrial metals and steel may fade. Rising steel production in China and lower demand for steel in the U.S. will lead to pricing problems for producers. But metals and mining stocks start the year with strong earnings prospects.

The materials sector includes gold mining, which has a life of its own. Gold price momentum is upward, so many analysts suggest overweighting this subsector, which has a 5.6% weighting in the S&P 500.

> Industrials. This diverse sector’s overweighted position reflects analysts’ expectations of average earnings gains of 15% in 2007. The big question is housing and whether the industry slump will hit bottom this year or continue into 2008.

Transportation stocks may fare better, thanks to higher volume of business, airlines’ tentative steps to restrict flight passenger capacity and capacity-straining volumes for railways. Takeovers may also create profits in the trucking industry.

The Value Line Investment Survey expects gains for human resources and employment service companies, as well as industrial services, office equipment and supplies, and electrical equipment.

Continental Airlines Inc. is regarded as a survivor in the airlines business and as having expansion possibilities through a takeover.

> Consumer Discretionary. Despite slower consumer spending resulting from smaller gains in real disposable income, analysts see opportunities in many parts of this broad sector. Media firms — cable television, entertainment and publishing — look attractive. Old-line media are getting into online services, and some may charge for access.

Retailing, conventional and online, is gaining. Home entertainment sales are expected to be strong, but price discounts are hurting electronics retailers.

On the downside, housing-related industries lack appeal. These include furniture and appliances, as well as building-supply firms.

> Consumer Staples. This has been one of the weakest-performing sectors over the past five years, and analysts still expect underperformance. They also expect major restructuring.

One attractive part of this sector is U.S. multinational firms, which will be helped by a weaker US$. Higher consumption makes wine and distillery stocks appealing. Organic foods have been a growth industry, and conventional supermarkets are making serious efforts to get into this area.

> Health Care. Pharmaceuticals account for half the weighting in this sector. The drug-discovery pipelines of the major firms have failed to deliver significant new products, resulting in acquisitions and corporate shakeups. Analysts are waiting to see how these moves work out. They expect more merger and acquisition activity. Growth will come from smaller biotechnology/genetics firms and makers of medical devices.

> Financials. This is the largest industry sector in the U.S., and analysts expect gains in 2007, despite the threat of housing mortgage defaults and “early distress” signs in the high-yield bond market.

Insurance stocks may escape the effect of credit defaults. In Value Line’s opinion, property and casualty insurance stocks, as well as securities dealers and investment companies, are among the most timely industries for investment. S&P, however, expects competitive pricing will cut into results for P&C insurers and reinsurers.

Bank mergers will continue, mainly involving mid-sized and regional banks. That probably will push up multiples, given the higher valuations that followed the 1990s’ consolidation boom.

> Information Technology. This large sector is still struggling to recover from the 2000-01 meltdown. Prospective gains from the low post-2001 earnings base are high.

Analysts expect leading earnings growth from semiconductor and semiconductor equipment firms. According to Value Line, these rate highly for timeliness. One top-rated stock is Integrated Device Technology Inc., with a projected 16% earnings growth rate.

S&P expects strong earnings gains from home entertainment software providers. Computer software, infotech consulting and application software are other favoured groups.

Business services provider Paychex Inc. is also viewed as a software provider. It has S&P’s highest quality rating and a projected 16% earnings growth.

> Telecom Services. Earnings prospects are strong, despite intensifying competition. Stocks’ rising price momentum from 2006 will carry into 2007. Old-line telephone utilities and cable-TV systems are vying to sell multiple services to consumers — package deals for wireline service, Internet access, video service and wireless phones.

The new AT&T Inc., with its projected 9% earnings growth, is highly rated. The firm and its predecessor have paid dividends since 1984, with the current yield at 4.1%.

> Utilities. Now only a small portion of the U.S. market, utilities reported good earnings gains in 2006. But prospects for 2007 are not as bright. Water utilities and water-treatment companies continue to hold appeal. IE