As a new year approaches, global market analysts and pundits will polish their crystal balls and issue proclamations about where to put your money. So it's worth paying attention when investment strategists at Merrill Lynch & Co. offer an early preview of investment ideas they expect will be the foundation for their research in 2007.
The 10 themes that Richard Bernstein, Merrill's chief investment strategist, and colleague Kari Pinkernell outlined in a report to clients this week all share a common goal: finding industries and companies at attractive valuations that can grow earnings against the backdrop of a coming worldwide economic slowdown.

"Although it is getting harder to find growth themes that have not already been exploited because of the continued abundance of liquidity and leverage, we do offer several growth themes that we feel have an unrecognized twist," the report notes.
The Merrill strategists foresee an anemic economy impacting energy and commodity prices and big-ticket consumer spending, creating a "Darwinistic" market where "survival of the fittest determines stock market performance." In this case, "fittest" applies to large companies in developed markets with strong
financial health and a global footprint.
The main obstacle to growth is that short-term interest rates are higher than long-term rates, the Merrill report explains. Typically, this topsy-turvy situation, known as an inverted yield curve, has resulted in weaker corporate profits.
"Every yield curve inversion since 1966 has been followed by a profits recession," the Merrill report says.
In the hunt for earnings growth next year, the Merrill strategists suggest that investors consider the following: large-cap stocks over small-caps, and developed markets over emerging markets; technology, media and defense stocks; triple-A rated corporate bonds; non-U.S. stocks that pay dividends; and Japanese consumer stocks.
Conversely, the strategists recommend that investors reduce portfolio exposure to these areas: retailers, with the exception of discount retailers; financial stocks, except for multiline insurers; and commodity and energy stocks.

Here's a look at the report's 10 themes:

No. 1: Buy large-cap stocks in developed markets

A broad case for large-caps has been made for some time by some Wall Street analysts who observe that small-cap and midcap stock performance has trumped larger rivals for several years running - an unusually long stretch. Large-cap shares have made a comeback this year, in fact, reflecting the Merrill
strategists' belief that in a weaker economy, bigger is better.
Highly rated companies on Merrill's U.S. stock buy list now include Coca-Cola Co. (KO), PepsiCo Inc. (PEP), McDonald's Corp. (MCD), 3M Co. (MMM), DuPont (DD), General Mills Inc. (GIS), Kellogg Co. (K), Procter & Gamble Co. (PG) and Walgreen Co. (WAG)
"Larger companies are better able to keep their earnings growing," noted Duncan W. Richardson, chief equity investment officer at mutual-fund company Eaton Vance Corp.
"We've been encouraging folks to consider asset allocation shifts from other assets to U.S. equities," Richardson said. "The U.S. market is very reasonably valued. We may look back in three to five years and say the most conservative blue-chip area was the cheapest, and maybe the best performing."
Seeking shelter in developed markets follows similar logic. Emerging markets tend to be export-driven and lack a vibrant consumer class to provide diversification and protection from external shocks, such as slack demand from major customers.

No. 2: Technology

The technology sector overall is still expensive, the Merrill report notes, but "some of the larger, higher-quality technology companies are indeed undervalued. It's hard to find an area in the entire global financial markets that has been as disliked as large-cap, high-quality technology," the report
adds.
Technology firms that Merrill stock analysts favor include Google Inc. (GOOG), Microsoft Corp. (MSFT), Hewlett-Packard Co. (HPQ) and IAC InterActiveCorp (IACI). Edward Yardeni, chief investment strategist at Oak Associates, differs with Merrill's view in his bullish belief in a consumer-led economic expansion.
With technology stocks, Yardeni looks for companies that stand to profit from corporate upgrades of computer systems. Microsoft's launch of its new Vista operating system next year, for example, "could give a nice bounce to a lot of the software companies," he said.

No. 3: Media

"Investors who are interested in U.S. consumer stocks should focus on the media industry," the Merrill report says. "Media has been one of our prime turn-around industries during 2006." The firm's stock analysts are particularly bullish on News Corp. (NWS), McGraw-Hill Cos. (MHP) and Time Warner Inc. (TWX) Demand among consumers and businesses for Internet and broadband connections
is growing rapidly, Yardeni said, which is good news for telecommunications companies that develop networking equipment and technology and media companies providing and distributing Internet video content.
"Communications equipment will benefit from the earnings revival we're seeing in telecommunications services," Yardeni said. "Internet video will become a big business. We'll need a lot more broadband, routers, switches, semiconductors particularly designed for this technology."

No. 4: Military expansion

Merrill's recommendation to focus on military contractors and suppliers is reflective of geopolitical realities that the strategists don't see changing anytime soon.
"A global arms buildup appears to be underway as defense spending continues to rise around the world, fueled by economic and political tensions and the increased threat of terrorism," the report states.
The strategists note that global military spending has increased by 25% in the past five years: "While the pace may not accelerate meaningfully during the next 10 years, all indications suggest that spending will continue to grow." Companies on Merrill's buy list that could benefit include Boeing Co. (BA) and
Honeywell International Inc. (HON)

No. 5: AAA-rated corporate bonds

Merrill's argument for triple-A rated corporate bonds - top-tier on the borrowing ladder - again is part of the search for high-quality balance sheets. But triple-A paper is scarce, which is another point in its favor, Merrill says. Just six non-financial U.S. companies are rated AAA by Standard & Poor's Inc.: General Electric Co. (GE), Johnson & Johnson (JNJ), Exxon Mobil Corp. (XOM), Pfizer Inc. (PFE), United Parcel Service Inc. (UPS) and Automatic Data Processing Inc. (ADP).
Marilyn Cohen, president of Envision Capital Management Inc., a Los Angeles investment advisor that specializes in bonds, also recommends double-A rated corporate bonds and triple-A rated debt from government agencies such as Freddie Mac (FRE) and Fannie Mae (FNM).
"The theme is to try to step around the land mines," Cohen said.

No. 6: Non-U.S. dividend-paying stocks

Strong companies that pay bondholders regardless of economic conditions are also likely to pay regular stockholder dividends. The Merrill strategists suggest broadening horizons to include dividend income from non-U.S. companies. When the U.S. dollar is weak, payments made in non-dollar currencies are worth more to U.S. investors.
"Within the U.S. this is a relatively undiscovered investment theme," the Merrill report says.
One exchange-traded fund that tracks an index of non-U.S. dividend payers is PowerShares International Dividend Achievers.

No. 7: Japanese consumer stocks

Japan's long-dormant consumer class provides another timely opportunity, the strategists note.
"Consumer-sector opportunities in Japan may just be revving up," they write.
"Early-cycle stocks (those that tend to do well during the initial stages of an economic recovery) are likely to outperform. Home building, retailing and similar groups have not been market leaders in Japan for many years. We think that could change."
Mark Headley, lead manager of the Matthews Japan Fund (MJFOX), notes that steadily improving growth in jobs and wages is enticing traditionally thrift-minded Japanese consumers to open their pocketbooks.
"Trendy retailers that have good models and run a good business are doing very well," Headley said. "They should be in a good position for a long time to come."
About one-third of the Matthews Japan portfolio is committed to consumer companies, including property and electronics companies. Among the fund's largest positions: Ryohin Keikaku Co. (7453.TO), whose popular Muji stores offer high-end design at affordable prices, and Sekisui House Ltd. (1928.TO), Japan's largest home builder.

No. 8: Sell retailers, except discount retailers

The optimistic view of Japan's consumer sector counters a grimmer outlook for U.S. consumers. "Sell retailers, or rotate in discount retailers," the strategists advise.
As 2007 unfolds, the slowing economy could darken consumers' mood and curtail demand for luxury goods. In this climate, discount retailers hold up well. "During previous profits recessions, discount retailers have tripled the performance of luxury retailers," the researchers note.

No. 9: Trim exposure to financials, except multiline insurers

Likewise, the financial sector is highly susceptible to a financial crisis or watershed event, the Merrill strategists say, not least due to its high
valuation relative to the market.
"Every Fed tightening cycle in the past several decades has ended in a financial crisis of some sort," the report warns. "If history is any guide, multiline insurance may be the safest haven in the financials sector." Insurance stocks on Merrill's recommended list include St. Paul Travelers Cos. (STA) and
Aflac Inc. (AFL)

No. 10: Reduce stakes in energy and commodities stocks

Perhaps the most controversial call in the provocative report is the strategists' contention that a bear market could strike energy and commodities stocks.
"Listed commodities (including oil) appear to be priced 60% above what could be justified by fundamental supply/demand factors," Merrill says. "There could be substantial downward pressure on energy prices for a reasonably long period if demand continues to slow."

By Jonathan Burton