Has the bull market run its course?

Investors got skittish as bond yields rose in June. But top strategists say there are still opportunities to be had in 2007. Fortune's Katie Benner reports.

By Katie Benner, Fortune reporter

(Fortune Magazine) -- Oh, what a glorious first half it was for the stock markets this year! Share prices shrugged off recession warnings, they brushed off the subprime loan meltdown, and they scoffed at the Shanghai stock scare. By June 4 the S&P 500 index was up 9.4 percent for the year.

Then came the market equivalent of kryptonite - inflation! rising bond yields! - and the markets staggered before regaining form. As the second half of the year begins, stockholders are skittish, so we decided the time was right to consult Wall Street's top sages and pose the question on every investor's mind: Has the bull market run its course?

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Krosby says bond yields must reach 6% to hurt stocks.

Not just yet. At least, that's the consensus of the strategists we interviewed. The market will inevitably slump, they say, but that's unlikely to happen in the second half of 2007. "Don't panic," says Wayne Lin, an investment strategy analyst at Legg Mason. "There doesn't seem to be much out there to cause the market to tank in the next couple of quarters."

It's easy to see why investors are nervous. Six years of ultra-low interest rates have been a tonic for corporations, private-equity funds, consumers and, well, pretty much everybody other than income investors. Companies have lavished buybacks on their shareholders, and stocks have been propelled by a burgeoning wave of mergers and acquisitions. So couldn't a rise in borrowing costs bring the party to a halt?

Surprisingly, Lin argues that rising rates and yields on longer-term Treasury bonds are healthy signs. "Rates have been so low for so long, in part because there was a lot of worry that the U.S. economy would tank and that the Federal Reserve would have to cut interest rates [to stimulate growth]," he says.

Yes, rates have risen, but only modestly (to 5.1 percent for the ten-year bond as of mid-June). And the crucial point, according to experts, is that they're not about to soar. The Fed isn't likely to jack up rates substantially this year, say six strategists interviewed by Fortune.

(Heck, it seems as if only minutes ago everybody was expecting a cut.) And even if bond yields float higher, the strategists say, there's still plenty of room before there is real hurt put on the stock market. "We need to go to a 6 percent yield on the ten-year note to present an initial obstacle [to share prices]," says Quincy Krosby, chief investment strategist at the Hartford.

The surging rates and fears of inflation are blinding investors to the fact that the change is occurring for a happy reason: Economic growth is picking up. That could boost corporate profits and support stock prices. "People will buy equities in anticipation of production. They're a leading indicator of growth," says David Malpass, chief global economist at Bear Stearns. "Many stocks have been held back by overstated concerns about a slowdown in the U.S."

The combination of economic growth and relatively stable interest rates should ensure that two stalwart trends of recent years - buybacks and buyouts - roll on a while longer. Moreover, international markets remain strong. Finally, there's one nonfundamental factor that could help stocks, says Michael Metz, chief investment strategist at Oppenheimer.

"Alternatives to equities are not all that attractive. Real interest rates are below historical norms, and they're heading higher, and that makes bonds relatively unattractive. The residential real estate market is no longer an option and commercial real estate is way overpriced." It all adds up to a bull market for stocks - at least for a little while longer.

Many investors remember how rising interest rates increased the cost of capital and killed the private-equity boom of the 1980s. But the return of normal interest rates now doesn't mean a halt to borrowing. "

We won't continue to have this level of liquidity, but it takes a long time for these things to reverse," says Legg Mason's Lin. "It would take a real shock, like Enron, for corporate bond yields to rise high enough to put a stop to borrowing activity." Liz Ann Sonders, chief investment strategist at Charles Schwab, agrees. "There is still plenty of liquidity in terms of a strong money supply, relatively low inflation and generous lending conditions."

Investors can capitalize in several ways. Merger mania will probably benefit small companies, as it has over the past few years. The handful of megadeals get all the press, but the vast majority of the 300 acquisitions announced since the beginning of 2007 were smaller companies, says Sam Dedio, a portfolio manager at Julius Baer. Smaller fish are easier for the larger fish to swallow and easier for private equity to sell or take public again.

Regional banks could be one category ripe for consolidation, says Dedio, and he thinks Colonial BancGroup (CNB, $25) could be an enticing takeover candidate. It's a good-credit-quality lender based in Alabama and Florida that should benefit from demographic growth.

"Every day 1,000 people move to Florida, and the baby-boomers will only accelerate this trend," says Dedio. "As mortgage demand slows, it's positioned to benefit from the migration of retirees to the region. It also has great management." The stock trades at a price/earnings ratio (for the next 12 months) of 13, compared with 18 for the S&P, and the company just bought back stock.

Oil companies may find themselves on the block because they generate gobs of cash but are finding fewer reserves and investment opportunities. "This is where the great excitement will be, and we'll see enormous appreciation for exploration companies," says Oppenheimer's Metz. He suggests Canadian exploration company EnCana (Charts), which trades at 15 times forward earnings and has a strong balance sheet.

A desire to get a piece of biotech's fast growth could also fuel deals in the pharmaceutical industry. "There are more relationships with biotech companies now, and large companies are streamlining and cutting costs," says the Hartford's Krosby. Her company's funds have been buying Schering-Plough (Charts, Fortune 500), despite the fact that it trades at a relatively pricey 20 times earnings.

"It's a turnaround story," says Krosby, "and their deal-making and licensing agreements have been attractive." The company has been minting money on Vytorin, a cholesterol-lowering drug it sells with Merck, and the two are planning a new cholesterol medication. Schering also has enough cash on the balance sheet that Krosby believes it could buy stock or make an acquisition.

In recent years money managers have been beating the drum for international investing - from hot emerging markets to long established economies - because growth overseas has trounced growth in the U.S. With the recent interest rate hike at the European Central Bank that took rates in most of Europe to a six-year high, it looks as if central bankers in the region believe the trend isn't about to abate.

Rate strategists say the Bank of England and the Bank of Japan should also pump up their benchmark lending rates by the end of the year, creating a case for economic optimism beyond the EU. "The real spurt of growth over the next year will come from outside the U.S., so you want to own companies that will participate," says Metz.

One way to play that trend is to buy big-cap U.S. names that have exposure to overseas markets or to exports. "If risk comes back into the market, which we think it will eventually, you want the total return you get from good-quality large-cap stocks that give a dividend and share appreciation," says Krosby. She says large diversified banks can benefit from the growth of retail and investment banking around the world.

One stock she thinks is worth a look is Citigroup (Charts, Fortune 500). Thanks to a series of debacles and missteps, it's trading at just 11 times forward earnings, and it's under pressure to take drastic measures such as jettisoning CEO Chuck Prince or even breaking itself up. "We'll see more measures to push up the stock price, and it pays a good dividend while you wait for it to deliver in terms of share price," says Krosby.

Boom times around the globe have created demand for roads, rails, airports and homes that will continue as nations from Brazil to Vietnam evolve into developed economies. Metz says the trend should benefit Caterpillar (Charts, Fortune 500) long term. The maker of bulldozers has a P/E of 13 and more than a decade of steadily increasing dividends (the stock currently yields 1.8 percent).

As globalization means that ever more goods and people will move between nations, Dedio is betting on an explosion in shipping and travel. One stock that could benefit in his view: Boeing (Charts, Fortune 500). The company has been gaining market share on rival Airbus, and its planes are sold out for the next couple of years.

"Its earnings are already set to stair-step upward," Dedio says. Despite that, it's trading at a below-market P/E of 16. That makes Boeing a stock primed for takeoff, and it's a reminder that, even if the skies aren't completely clear, the real turbulence is still a ways off.

Jon Birger contributed to this article. Top of page