'87 investing may hold profit surprise

Prognostication on Wall Street has been, at best, an inexact science. Reams of fundamental and technical data are digested, but, as a noted market analyst admitted recently: It all boils down to ``intuition.'' Nonetheless, the data do provide a jumping-off point for acting on hunches. And the hunches from market pros for 1987 are pinned to a continuation of this year's slow-growth economic scenario.

Earnings disappointments born of a sluggish economy have dogged the Dow Jones industrials for six or seven months. But 1987 will be the year of ``earnings surprises,'' predicts Robert S. Salomon Jr., research director of Salomon Brothers Inc.

Salomon predicts 2 to 2.5 percent real economic growth next year, 3 percent inflation, and a further decline in interest rates. ``We believe the hopes for a cyclical boost will again be frustrated.''

Against that backdrop, overall good earnings are not expected, he figures. But tax reform and restructuring will bolster the profits among blue-chip companies.

``We've been on a huge binge of cutting costs and restructuring,'' he says. ``Companies are leaner and meaner. The question is, To what end?' The end, I think, will manifest itself in lower break-evens. That will result in favorable earnings surprises in a sluggish economy.''

Kodak's unexpectedly strong quarterly earnings, he notes, are a recent example of that developing trend.

Some companies will also get an earnings kicker from tax law changes, but analysts are split over whether these expected changes are already ``in'' the stock prices. Salomon Brothers identifies media, food, tobacco, restaurant, and household product companies as not only reporting higher earnings in 1986, but also paying less taxes.

Tax reform may also encourage buying in blue-chip stocks that offer fat dividends (utilities, international oils, foods). Until now, dividend checks sent to investors were taxed as ordinary income, which meant that up to 50 percent of the dividend gain might have gone to Uncle Sam. With the top income bracket falling to 28 percent, high-dividend stocks become a better value. And the tax changes make paying dividends more attractive to companies.

Also, the tax code will no longer favor capital appreciation stocks by taxing those gains at 20 percent. In 1986, both capital gains and dividends will be taxed at 28 percent.

In addition to better earnings leverage, the three-pronged Salomon Brothers investment strategy includes disinflation and interest-sensitive stocks. Salomon's current buy list favors consumer staples (beverages, cosmetics, foods, household products, drugs, tobacco) and financials (money-center banks, regional banks and thrifts, and insurance companies).

Basic industry stocks are underweighted, although Salomon analysts and many others see good gains from papers and chemicals as the dollar's drop enables them to pick up market share abroad.

Greg A. Smith, director of research at Prudential-Bache Securities, describes 1987 as ``the long-awaited year of better earnings'' and predicts a ``muddle through'' economy with a possibility of slightly stronger growth than this year.

Mr. Smith calls 1987 the year of ``the stock-picker.'' Broad investment themes based on the dollar, interest rates, and inflation don't hold much attraction in 1986, since he expects such economic variables to remain relatively stable.

But the thrust of Smith's investment strategy is entirely different from that of Salomon Brothers. Smith picks small, emerging growth stocks to provide the fireworks - not the blue chips. Recently, he recommended that aggressive growth funds beef up their holdings from 70 percent in equities to 85 percent.

Despite the tax logic favoring high-dividend stocks, Smith argues that investors are most concerned with getting a double digit return. In a low-inflation, stable rate enviroment, double digit returns are not easy to obtain from fixed-income investments. To get those gains, Smith predicts investors will leap into aggressive growth stock mutual funds.

The weakness in the over-the-counter averages also helps his case. After plummeting about 16 percent from their summer highs, the NASDAQ averages are still 10 to 14 percent off their peak. Meanwhile, the broader market averages have nearly retraced their September losses. This suggests that better values can be found among the smaller issues.

With the exception of small growth stocks, Smith thinks the market is fairly valued now. He ``seriously'' doubts investors will see ``a major up move in the stock market in 1987.''

Several prominent technical analysts, including Robert Prechter, editor of The Elliott Wave Theorist, a Gainesville, Ga.-based newsletter, believe the market is locked in about a 200-point trading-range correction. Somewhat higher new highs may even be hit. But ``time is likely to do as much damage to investor psychology as price is,'' Mr. Prechter says.

Nonetheless, he thinks a dip of 10 to 15 percent (a Dow low of 1,600 to 1,700) is likely in 1987. Beyond that, Prechter sticks with his long-term forecast of 3,600 to 3,700 on the Dow in 1988.

Robert Nurock, father of ``The Wall Street Week'' ``elves,'' expects the Dow may puncture the 2,000 mark shortly. From there, Nurock opts for two possible scenarios. One follows Prechter's fairly closely: ``Dow 2,000 may produce another reaction, instill concern ... but I don't think the Dow will hit new lows. From there, my target would be 2,400.'' The second possible outcome: ``The Dow goes through 2,000 like a hot knife through butter and keeps going.''

In any case, Michael Metz at Oppenheimer & Co. says that increased market volatility will make ``timing more important than in the past. There will be more traders, more sector-fund players, and that translates into more stampedes.'' Next year marks the end of the six-month capital gains holding period. And with the commodity markets mostly quiescent, speculators are likely to migrate to stock futures and options, Mr. Metz says.

In short, follow an (educated) hunch next year. And stay on your toes.

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