It’s the time of year when forecasts and prophesies are in the air, shaping investors’ expectations about 2007. From most quarters, the outlook is bullish. Economists are generally calling for a soft landing for the economy, and most expect the Fed to start raising rates again some time late next year or in 2008. Despite the weakening dollar and the still-uncertain housing outlook, the stock market is expected to head higher.

Among the more astute prognosticators making the rounds recently were some of the highly respected money managers from Legg Mason (LM$96). This outfit has gone through a tough year, assimilating its acquisitions of the money management division of Citigroup (C$52) and of Permal, a fund-offunds operation, which together doubled LM’s assets under management. As is so often the case, the mergers were a little more trying than expected, causing the company to miss some earnings targets and the stock price to drop about 20% in the past year.

Adding to the gloom, the fabled head of Legg Mason Capital Management, Bill Miller, has had a bad year. For a company with nearly $900 billion under management, the underperformance of one manager would not normally merit comment, but Mr. Miller is no ordinary manager.

Mr. Miller manages the Legg Mason Value Trust mutual fund, the only fund to outperform the S &P 500 in each of the past 15 years. Since its inception in 1982, the fund has earned nearly 16% a year (through September 30), compared with S&P 500 gains of slightly less than 14%. Over the years, Mr. Miller and his team have focused on finding companies selling at discounts to their estimate of intrinsic value, based largely on an analysis of discounted cash flows.

Most of the holdings in the fund would fall into the large capitalization category, and currently the top 10 holdings include a large power producer, AES Corporation (AES$23),Tyco International (TWC$30), Qwest Communications (Q$8), Sprint Nextel ($20), and UnitedHealth Group ($50). The portfolio is heavy on consumer discretionary and information technology stocks, as well as financials and health care.

The stocks that have hurt Mr. Miller’s performance this year include Sprint and UnitedHealth. He also owns 10%-15% of all the major homebuilders, which have been hit by the housing slump. Overall, the fund is off 4.5% year-to-date, considerably behind the S&P year-to-date gain of 13.2%. An unsentimental Morningstar has reduced his five-star rating to three stars.

Notwithstanding this year’s setback, Mr. Miller was pretty positive about the market’s prospects for 2007. He said it is now the middle of the Federal Reserve’s mid-cycle slowing of the economy, and that at this point in the cycle large-cap stocks typically begin to outperform. Among other positive elements in the current mix are a still-low level of inflation, high productivity, which is moderating unit labor cost increases, and a record level of stock buybacks and corporate buyouts.

Mr. Miller points out that stocks move in the same direction as earnings, and should likely follow expected earnings gains into 2007, despite concerns about high energy costs and fluctuations in short-term interest rates. He sounds exasperated with those looking for a recession, pointing out that in 25 years we have experienced only 14 months of recession.

His view is that if the Fed is doing nothing, as is currently the case, the message is that the economy is on a steady course. In other words, things are pretty good.

Mr. Miller is looking for price/earnings multiples to expand in 2007, and likens today’s scenario to the 1994-95 years. As with that period, the Fed has stopped raising rates, preparing the market for a significant move higher. He bolsters his case by pointing out that in the past 25 years, recessions have been preceded by several quarters during which interest rate spreads were higher than normal, which is certainly not the case today.

He is also rather bullish on the dollar. A slowing of the American economy will lead to some softness in imports, which should improve the trade deficit. Also, the weak dollar should attract considerable tourism, as well as stock market investors.

Overall, Mr. Miller is bullish about a number of sectors moving into 2007, including many which have been hurt this year. He thinks the large Internet stocks, homebuilders, health care managers and technology shares that have done poorly in the past few quarters are set to outperform next year.

The Legg Mason managers never fail to impress. This year, we thought they did well not to venture a few bullish remarks about their own stock. Legg Mason is selling way below its 52-week high of $140 due to reduced earnings estimates and Wall Street frustration over the time it has taken to integrate the new acquisitions. The stock is selling at 18.3 times estimated fiscal 2008 earnings (ending in March 2008). By comparison, Black-Rock (BLK$146) is selling at 21.2 times projected 2007 earnings; it seems quite possible that they may have some consolidation issues of their own going forward.

The money management business has long been desirable because of the steady flow of revenues and attractive growth opportunities. Legg Mason is generating excess cash, and will have about $250 million by the end of its first quarter, which may be invested in other acquisitions to round out its portfolio. The company has grown at more than 30% over the past 10 years, not including the impact of the Citigroup acquisition.

Just as we would not bet against Mr. Miller resuming his winning streak, so we would look for more good times ahead for Legg Mason.