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Dow's year-end rise a pleasant surprise

Fourth-quarter surge comes with a caution about what may lie ahead.

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Foreign funds again rewarded investors handsomely. World equity funds, which now oversee close to 1 in every 4 dollars in equity fund assets, soared 25.6 percent in 2006. Emerging- market funds, recovering from a sharp sell-off in the spring, surged 32.1 percent. Latin American funds added 44.1 percent. Their average annual gain of 31.7 percent over the past five years topped all US and international funds categories. European region funds also sparkled, with almost half their 33.7 percent annual advance owing to the effects of a weaker dollar.

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Money flows into stock funds were strong in 2006, but heavily skewed toward foreign offerings. Despite the market upswing, domestic stock funds were largely devoid of fresh inflows, says Mr. Tjornehoj. Besides international funds, money inflows have favored less volatile equity-income funds, which opt for companies with high dividends.

Wall Street strategists anticipate further, if less robust, gains in 2007. S&P's investment policy team, for example, projects a return of 8 percent for the S&P 500 for the year, with almost 2 percent attributed to dividends.

"The risk-reward ratio remains decidedly tilted toward equities," says Stanley Nabi, vice chairman of Silvercrest Asset Management in New York. Price-earnings ratios don't look stretched, especially for large-cap stocks with healthy balance sheets. Some slippage in corporate profits from peak levels shouldn't stymie stocks, as long as US economic growth doesn't dip below 2 percent and inflation remains mild, he adds.

Along with a host of other forecasters, Mr. Nabi expects "mega cap" stocks, the top tier of multinational companies, to be pace-setters. Their global reach, which typically accounts for more than one-third of profits, should help them weather any economic weakness at home. Small-cap stocks, whose valuation appears extended after a six-year run, may take a back seat to large caps.

Fred Dickson, market strategist for D.A. Davidson, agrees with the positive outlook, but with a caveat: "Investors will experience more price volatility, especially during the first half of 2007, and investment returns that will fall short of last year." he says, and Wall Street may be too optimistic in assuming the Fed will lower rates early this year.

Few analysts expect foreign markets to repeat this past year's strong showing. Still, steady economic progress in Europe, coupled with rising per capita incomes in emerging markets like India, Brazil, and Mexico should keep the upward trend alive.

One key question: How will the greenback fare? If the dollar reverses course and rises against the yen and euro, gains from international funds would fall.

What might go amiss in 2007? Sudden geopolitical crises, especially in the Middle East, could cause another spike in oil prices. On the domestic front, the potential ripple effects of a housing slump remain worrisome.

Noting that every recession since 1966 was preceded by a sharp downturn in housing starts, Mr. Clark frets that "we're probably only halfway through the current downturn." In the past six down cycles, the average decline in residential construction, from peak to trough, has been about 50 percent.

To date, the decline from the 2005 peak has been around 30 percent, he says.

To keep their portfolios flush in the months ahead, investors will have to stay well diversified among various asset classes, including international stocks, analysts say. Sector themes that have been hot for several years, such as energy and real estate, merit a more cautious approach.