Managers find themselves vexed about the economy's direction.

    A strong second half has the stock market on target for possible double-digit returns in 2006, but as investors look toward next year and beyond there seems to be a lot more hand-wringing than high-fiving taking place on Wall Street.
    Investors, it seems, have one eye on the Dow and the other on the Fed. "The market doesn't know what to make of things," says Max Bublitz, chief strategist for Seneca Capital Management in San Francisco. "This is a market that wants activity and guidance from the Fed."
    There are, of course, reasons for investors to be encouraged going into 2007. The Dow Jones Industrial Average, up nearly 14% in early November, hit record highs in 2006, with the S&P 500 and Nasdaq lagging a bit behind at around 10%. Considering that forecasters have been continually warning investors to brace for single-digit returns, it was a positive year.
    But it was also a year without any clear trends, without any breakout sectors and with a lot of questions about what to expect-or where to invest-in the months to come. Among the key questions were those surrounding the collapse of housing prices and to what extent, if any, this would ripple across the economy, possibly in the form of reduced consumer spending.
    As always, the course of the economy is another key concern, as is the Federal Reserve's stance on interest rates and inflation-particularly since the Fed's run of 17 interest rate reductions over the past two-and-a-half years finally seemed to have the desired effect of slowing down the national economy in 2006.
    "The key theme was, the mid-cycle slowdown we were looking for finally arrived," says Phil Orlando, senior portfolio manager for Federated Investors Inc. "I think the Fed is correctly waffling on this inflation issue. On the one hand, you have a decelerating economy. On the other, core levels of inflation are stubbornly higher than (the Fed) would like to see."
    In 2006, value once again trumped growth-the sixth time in seven years that has happened-with the Russell 2000 Value Index up 13.26% as of the end of September compared to 4.21% for the Russell 2000 Growth Index. Taken with the strong possibility of a continued economic slowdown in 2007, the extended value run has prompted many managers to add weight to their large-cap growth allocations, although exactly what differentiates growth and value is somewhat fuzzy these days.
    The precarious state of the domestic economy also has many managers turning to the international market, with demand for international holdings cropping up in a number of investments, including stocks, REITs and the ETF markets. "It's because of need," says Michael Petronella, president of Dow Jones Indexes, which in October launched with Wilshire Associates a family of indexes designed to provide a broad measure of world equity indexes. "Managers are looking to improve the importance of their funds and to seek out alpha internationally."
    Richard Driehaus, chairman of Driehaus Capital Management in Chicago, says he's turning to overseas markets more frequently in his search for aggressive growth opportunities. He sees domestic economic growth headed for a slowdown in 2007, as the economy bears the burden of absorbing an oversupply of housing.
    "There's been a lot of speculation, and a lot of people that own homes have withdrawn money from equities and now their home values are flat or falling," he says. "That creates economic consequences for financial institutions and those who bought the mortgages. These things don't correct in three to six months."
    The international market, however, is a story of robust growth-creating far more favorable opportunities for investors, he says. Driehaus says he favors Japan and the rest of Asia, specifically the emerging markets of China and India, which together hold 40% of the world's population. "Their growth rates are stronger and starting at a lower base, and they're becoming more capitalistic," he says.
    One example of an international investment theme is the previously unfavored basic materials sector, where tight supplies and high demand have created an ideal scenario for investors. Specifically, Driehaus is making a play in the uranium sector, where high demand for a scarce resource has uranium mining companies such as Paladin Resources and SXR are poised for high growth.

Domestically, Driehaus says he's had to dig deeper to look for individual growth opportunities, resulting in holdings such as San Diego-based Illumina Inc., which generates large recurring revenues through large-scale analysis of genetic variation and function. "It's going to be sort of a tough market [domestically] because there really are no major themes," Driehaus says.
The global economy has also entered into the thinking of some value managers, despite the fact that value, on average, was able to achieve solid returns in 2006 on the domestic front. James R. McGlynn, portfolio manager of the large-cap value Summit Everest Fund, brought investors a year-to-date return of 17% as of October 31.
    McGlynn reaped rewards by making plays in the telecommunications and utilities sectors this year, but his best performers were actually an eclectic mix of names-including a number of 'tweeners that have been simultaneously appearing among the holdings of growth and value funds. In the case of Summit Everest, this would include companies such as Cisco, AT&T and Exxon.
    Looking ahead, however, McGlynn is trying to bulk up on industrial companies that are underpriced and do a sizeable amount of business overseas. Among the companies he's been buying towards this goal are Tyco, 3M, Ingersoll Rand and Honeywell. "It partly has to do with the traditional thinking that once the economy slows down, and profits fall off a cliff, the business will still be there for these guys overseas," McGlynn says.

But he says each of the companies also has an appealing story. Tyco, for example, is due to be broken up into parts in 2007, and McGlynn reasons that investors can only gain from the breakup. Ingersoll-Rand's share price has taken a beating due to the perception that it is especially susceptible to fallout from the housing correction. But McGlynn notes the company is buying back stocks and still reporting good earnings throughout the rest of the world.
    At the Wintergreen Fund-a multi-cap value fund started last year-foreign investments have steadily risen from about 40% to 50% this year. The fund's prospectus provides for up to 100% in foreign holdings.

Portfolio Manager David Winters says he expects the emphasis on international investments to only increase in 2007. "We view the world as our oyster and there is a lot to do out there and so our focus is very much international or global investing next year," Winters says.

Like many of his colleagues, Winters has taken a step back from the domestic market-where he feels the Federal Reserve's 17 interest rate hikes and the falling housing market will add up to a slowed domestic economy-and looked toward Asia for value.

Among his holdings are The Hongkong and Shanghai Banking Corp. and the London-based Anglo American mining company, which have impressed     Winters with their balance sheets and global reach. Speaking of Anglo American specifically, he says the company has heavy concentrations in diamonds and platinum, and a share price that has been beaten down by commodity investments going out of favor. "So much of the markets are moved by sentiment and the market is very negative on commodities right now," he says.

Winters says he becomes more "intrigued" with the energy sector as oil prices get lower. That, he says, could lead to the same type of reversal in investor sentiment that was seen in the commodities sector.

"Instead of having euphoria in the energy patch, you have a degree of increasing fear that can often create disconnects between what things are worth," he says. "If you're thinking rationally and long-term you can oftentimes find securities that are quite good."
    Quincy Krosby, chief investment strategist for The Hartford, says the shift toward domestic large-cap value stocks this year represents a win-win scenario in the eyes of investors, doubling as both a defensive move against an economic slowdown and an indirect way of taking advantage of overseas growth.
    "It's a broad play," says Krosby, who is weighting portfolios toward large-cap and international in 2007. "We would look at it as being across a number of sectors and getting the companies that are best poised to continue growing and conducting a global business."

She expects large caps to perform in the 7% to 9% range next year. Krosby adds, however, that trying to distinguish between value and growth in the large-cap space is becoming tricky, as the prolonged outperformance run of value has created a lot of overlap in value and growth multiples. "Managers in pure value have picked up so many companies that have been called growth, I find it hard to look at portfolios at this stage and tell the difference," she says.
    Multiples have narrowed so far, in fact, that the anxiety continues to build on Wall Street over exactly when growth is going to overtake value. As Krosby noted, it's in some cases a moot question, as companies such as Microsoft, Dell and Oracle have been appearing among the holdings of value as well as growth mutual funds.
    The compression of the gap between value and growth comes as the result of a six-year pullback from the unprecedented premiums growth had over value at the height of the technology boom in March 2000. In that time span, according to Morningstar, the price-earnings ratio of the large-cap growth sector has shrunk from 40.13 to 21.05. For large-cap value, the change has been from 17.82 to 14.89. As of September, according to Morningstar, the price/book ratio of growth vs. value was 3.70 to 2.37, respectively. In March 2000, the difference was 8.13 to 2.86.
    At the Sun America Value Fund, the narrow divide between growth and value has led to the addition of "growthier" companies to the fund's holdings, says portfolio manager Steven Neimeth. "For many of these companies, they're trading at the lowest multiples they've seen in the last ten years," he says.

Among the companies he recently has added, with an eye toward a rising share price in 2007 or beyond, is Yahoo, which has a valuation in line with the overall market but a growth rate that is two or three times the market average, Neimeth says. The company's share price, meanwhile, was down to a 52-week low in October. "Earnings growth is likely to slow, but it's still far superior to the overall market," he says.
    Other recent additions include Motorola, which Neimeth bought at 15 times next year's earnings and with $5 per share of cash on their balance sheet. "They've been weak due to concerns about growth in the wireless industry," he says. "But it appears Motorola has a technological advantage for the next couple of years due to many years of high research and development spending."
    Another one of Neimeth's value picks is Exxon, which was trading at about 11.5 times forward earnings in October-only the second time in 20 years that the stock's multiple has been that low. The average multiple during that time was 16, he says. "Even if you believe oil prices won't go higher, if it just gets halfway back to its average multiple it will still be up significantly over the next year," he says.
    Lincoln Anderson, chief investment officer of LPL Financial Services in Boston, sees the growth versus value puzzle as the biggest question entering 2007-something he recognized earlier this year when he began digging into why so many recommended managers were underperforming. "What we found was that a lot of them have been shifting to the right, towards growth," Anderson says. "So the value guys are getting more blendy and the growth guys are getting growthier."
    At the same time, he notes, the passive indexes, which are market-cap weighted, have been moving to the left in a reflection of where money is pouring into in the overall market. It is, Anderson says, a mirror image of the late 1990s, when growth completely overshadowed value. With the indexes shifting left, and the managers shifting right, he says, "I'm surprised we haven't had worse performance."
    A question investors should ask themselves in 2007 is not just whether or not they should be in growth, but what kind of growth, says Rob Brown, chief investment officer with Genworth Financial Asset management Inc. in Encino, Calif. "The most glamorous, the most momentum-driven or story-driven growth is somewhat susceptible," Brown says.
    He is instead focusing on high-quality growth, examples of which include Microsoft and Amgen. This group consists of growth companies with proven business models, conservative financials and "rock solid" profitability, rather than the wildly speculative types of companies that were churned out of the technology sector in the late 1990s.
    "Quality large-cap growth is the single most undervalued chunk of the stock market," Brown says.