From the January 2006 issue of Investment Advisor • Subscribe!

January 1, 2006

Mostly Sunny or Partly Cloudy

The economic climate for 2006 looks fair and mild, but a few forecasters see storm clouds on the horizon

Like most questions, the answer depends on whom you ask. We are fortunate here at Investment Advisor in that we have not one expert to consult, but nine wise members of our monthly asset allocation panel. Among these nine experts and their colleagues, analysis of the same data sometimes leads to different conclusions. For the most part, the panelists were guardedly optimistic.

Generally, there is a consensus that inflation will be mild and that the impact of energy prices, while it may place some drag on the economy, will not necessarily be as bad as had been feared. "Crude oil is going to come down steadily, and that will help the economy and will help cool off inflation fears," says SunGard's Gail Dudack. "This will also allow P/E multiples to expand rather than contract as they have done throughout 2005."

Most of our panelists indicated that the continued growth in productivity and GDP would offset the potential for inflation, thus causing the Federal Reserve to stop raising rates at some point under 5%. It's also collectively believed that the dollar will be strong relative to other currencies.

Potential negatives include the bursting of the residential real estate bubble, or at the very least a leveling off of the dramatic increase in home prices of the last few years, which could force some over-extended speculators into selling into a crowded and declining market. There's also the continued uncertainty about energy prices and interest rates, which are the big ifs for 2006.

As they say about opinions, everyone's got one. Following are our panelists' educated opinions on the outlook for this year. We've also included a chart showing their predictions of a number of major economic indicators, as well as one showing how on the money they were at this time last year. Knowing advisors' penchants for taking the long view, we've also included data tracking predicted and actual inflation for the last 15 years.

Lincoln Anderson, LPL Financial

"I think it will be a pretty good year," says LPL's managing director and CIO, displaying his typical optimism. "I don't see us running out of running room here on the expansion. There may be a little bit of a drag from energy prices if they stay this high, but not enough to kill theexpansion."

As Anderson sees it now, 2006 will finish with GDP having a 3.5% to 4% boost and the creation of some 1.5 million jobs. Although there's been a great deal of talk about interest rates, he's not that concerned. He points to a core inflation rate of 2% and an overall inflation rate of 4%, the difference between the two being driven by the dramatic surge in the cost of energy. "I look at that and ask, where are we going to go next with energy in 2006? My guess is that energy prices will be flat or down," he ventures. "I could be wrong, but I think the odds are better for an energy price decline than for further rises."

In terms of stocks, he's of the opinion that the economy will shift from a consumer-led expansion to a business-led expansion, but a continued expansion nevertheless. "That means you'll see a lot more inventory investment, a lot more business fixed investment, and more technology investment. I think the sector that should do well in that is technology, which has not done all that well lately."

The areas he finds least attractive are cyclicals that did well in 2005--precious metals, materials, and energy.--Robert F. Keane

Mark Balasa, The Alpha Group

There's good news and bad news for equities in 2006, reports the Alpha Group's Mark Balasa. "There has been a reduced risk premium for stocks in the last several years," he says. "That is going to continue." Despite that trend, he expects the markets to improve slightly by the end of 2006, with the Dow closing at 11,800, the S&P at 1,350, and the Nasdaq finishing off at 2,450. GDP will end 2006 at between 3.5% to 4%, he adds, while inflation will steady at 3%.

"Large growth stocks have been beaten down for the better part of five years," he explains. "We feel that it is large growth's turn to take off, but not by an enormous margin." Small internationals should fare slightly better in 2006, Balasa continues. "This asset class has been taking off for the last several years, but there is still room for improvement."

Balasa suggests pulling away from commodities as well as small value. "Commodities are going to do poorly while small value is going to fall apart and be at the tail end of the pack."

He adds that the political state of the nation will have some effect on the financial markets. "War affects the psychology of investors, especially if it is not going well," he explains. "If the political turmoil is figured out, that will begin to gradually help [investor confidence]."--Megan Fowler Robert

Richard Bernstein, Merrill Lynch

Expect meager returns from equities in 2006, reports Savita Subramanian, a strategist with Merrill Lynch, speaking on behalf of IA panel member Richard Bernstein. She expects all asset classes to be relatively flat with single digit returns. "Strategists are overwhelmingly bullish in equities [for 2006]," she explains. "That is usually a contrary indicator. When a herd mentality or group think forms in the equity market, it is typically already priced into the market." As a result, she says "returns on capital will be highest in areas where capital is scarce." However, "every asset class has had record inflows of capital [in 2005], so returns on all asset classes [in 2006] are going to be meager."

She is of the opinion that all returns are going to be similar this year and suggests that investors reap the benefits of diversification, but stay away, however, from foreign-exposed sectors such as technology. "Technology has the highest percentage of foreign sales of all 10 sectors," she says. "There is a negative relationship with earnings in this sector to a strengthening dollar." The U.S. dollar is up 12% or 13% year-to-date, and will end 2005 with 15% appreciation, she suggests. This sector sells heavily in foreign currency and "the translation is going to hurt." Finally, housing prices will stagnate in 2006 and emerging markets will share the pain with the U.S. consumer. "Our overall view is that the housing market will not implode but it is going to slow," she says. "People have been using their houses as ATM machines through refinancing." That will end, and the decrease of consumer spending will have a negative impact on the global economy.--Megan Fowler Robert

Gail M. Dudack, SunGard Institutional Brokerage, Inc.

SunGard's Chief Investment Strategist feels 2006 is going to be a strong year, predicting the Dow will finish off 2006 at 11,600, the S&P will end at 1,420, and the Nasdaq will close at 2,520. "1,420 is a strong target for the S&P," she says. "That is a 13% gain from where we are now and is doable on simple valuation." Dudack believes the driving force behind the increase will be oil.

Industrials, healthcare, and technology are the three industry groups she anticipates will perform best in 2006. "Healthcare is an area that grows faster than GDP," she explains. "It has been under the cloud of big-cap pharmaceuticals, but it will begin to do well." Industrials will also perform well and will retain high earnings. Dudack advises staying away from staples and consumer durables, however. Consumer stocks will be handicapped by a stronger dollar and consumer spending leveling out at a lower but still robust pace, she explains.

"That is a problem for staples as they are truly global, and global [sectors] have an earnings translation risk."

Over all for 2006, Dudack says profit margins will be the key to successful investing. "A stronger dollar will pressure consumer staples/durables' profit margins, but the economy, the dollar, and the stock market will do better than most people expect, especially in the first half of the year."--Megan Fowler Robert

Mark Keller, AG Edwards & Sons

The U.S. economy ended 2005 on a healthy note, Keller says, and it will continue to grow in 2006, albeit at a slightly slower rate as a result of rising interest rates, the one big issue for the New Year. The Federal Reserve is likely to increase rates only in small increments, but even so, every move it makes will have an impact upon economic growth that should not be underestimated.

"A lot of folks think they know what the Fed is going to do, but over the years, this has not proven to be easy to gauge," Keller says.

Still, with the overall economy in good shape, Keller is optimistic, and his firm forecasts a good run for the U.S. stock market in 2006, based on a strengthening of the dollar. Last year, AG Edwards' experts had predicted a strong run for international equity markets, and 2005 turned out to be a great year for foreign stocks. That headwind is likely to peter out in 2006, though, so Keller favors large-cap U.S. stock, based on valuations, he says. Non-cyclical sectors such as consumer staples and healthcare are the places to be for long-term investment, and the stocks of energy-related companies are also a good bet, as these entities continue to post strong earnings and cash flow, he says. Areas to avoid include the basic industry and commodities sectors--namely metals, chemicals and building products--as well as retail and other cyclical industries.--Savita Iyer

Stuart Schweitzer, JP Morgan Chase

"The U.S. economy is the most flexible and adaptable in the world," Schweitzer says. "Its strength never ceases to amaze me."

As he predicts a year of solid economic expansion, Schweitzer nonetheless believes that the strength of the economy will lead the Federal Reserve to continue to raise interest rates to wash out any potential for inflation. The Fed Funds rate could rise to around 4.75% to 5% before the agency takes a breather, he says, and this raises the risk of a slowdown in the residential housing market, and in turn a drag on consumer spending, which kept the economy robust in 2005.

All the same, there is nothing to be too gloomy about, he counsels, and the fact that inflation can be controlled will mean that global economic expansion can continue without serious disruption. As such, non-U.S. equities will have another strong year relative to U.S. stocks, Schweitzer expects. Overall, he favors equities to fixed income instruments, given that rates are going to rise in 2006 (but within fixed income, he'd go for shorter maturities over longer).

In general, Schweitzer favors large-cap stocks over small caps, and his firm has become more optimistic recently about the likely performance of growth stocks relative to value.--Savita Iyer

Gary Shilling, A. Gary Shilling & Co.

In his more than 15 years as a member of the Investment Advisor asset allocation panel, this advisor, economist and Forbes columnist from Springfield, New Jersey, has consistently charted his own course. His outlook for 2006 is no exception.

He identifies a number of forces that are likely to impact investing this year. "The world is sloshing with liquidity," he observes, and inflation is low, despite high energy costs. The combination of these two forces means that investment returns are low, which maintains the strong climate for speculation. "With this speculative climate and low returns, there's a tremendous reaching for return, in other words, moving out the risk spectrum," says Shilling. "Finally, we've got the insatiable American consumer who doesn't have real income to support spending, but as long as he's got assets he can borrow on, he shows every sign he will keep spending."

The bad news for that consumer is Shilling's prediction that the housing bubble will burst, having a major negative impact on consumer spending and triggering a major recession and a bear market in equities worse than in 2002. "I think we'll see a global stock decline," he predicts. "When U.S. consumers retrench, it's very tough on most other countries in the world. U.S. consumers are their first and last-resort buyers for their excess goods and services. I think this is a particularly important theme because we've had all this money rush out of the U.S. into foreign markets--emerging and major--and I think that's in jeopardy."--Robert F. Keane

Liz Ann Sonders, Charles Schwab & Co. Inc

Unlike many of her peers, Sonders does not think that rising interest hikes will have a major impact on the U.S. economy in 2006. "I have a benign look on inflation, and the inflation risk in 2006 is less than in 2005, so the Fed will not be so aggressive as people believe," Sonders says. "Yes, they will hike rates, but rates are still low and there is a lot of cash in companies, so CEOs who until now have been cautious about expenditure are going to start spending."

The main driver of economic growth will be the corporate sector, Sonders believes, with companies taking over from consumers, who in 2005 benefited from low mortgage rates and other incentives that allowed them to spend and spur economic growth.

As such, Sonders foresees a strong 2006 for the U.S. economy, and recommends an overweight in large-cap stocks in sectors such as healthcare and technology, both of which are dominant in growth indexes. Energy and utilities are her sectors to underweight, mainly because valuations have climbed to unsustainable levels. "With rates rising, there are other places to get yield," she says.

While Sonders is neutral on U.S. equities, she urges a strong overweight toward emerging market stocks, which she believes will do very well in 2006 by virtue of appealing to a far greater number of investors than ever before. She also favors Japanese equities, as they have had a very strong run in 2005. The Japanese market has had a lot of false starts, she admits, but this time, all the ingredients are in place for a longer-term, more sustained period of growth that can only bode well for foreign investors.--Savita Iyer

Sam Stovall, Standard & Poor's

"We think it's going to be a positive year," says S&P equity market strategist Alec Young, pinch-hitting for chief investment strategist Sam Stovall, adding that they anticipate the S&P 500 will be at 1,360 by year's end. "That's roughly a 7% absolute return and a 9% total return. A high single-digit return qualifies as positive in our book, given that from an asset class point of view you can't get anywhere near that kind of opportunity in the fixed-income arena without buying some pretty junky stuff."

The strategists at S&P were particularly heartened by the announcement in December that removed the word "accommodation" from the Fed's policy statement. "Our economists are calling for another quarter-point move in January and a final quarter-point move in March at Bernanke's first meeting, leaving us at a peak of 4.75%, which is relatively benign."

"Another driver for our outlook is earnings. For 2006, we see earnings up 11%, a slight deceleration but nevertheless very respectable, especially in a low-interest-rate environment. Obviously, long-term interest rates impact P/Es. The higher the long-term rates, the lower the multiples investors want to pay. Even though the Fed has been raising for a while, long-term rates have stayed very benign, we're at 4.5% on the 10-year and that's positive for housing, because that's what controls the mortgage market. --Robert F. Keane

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