Goodbye, Mister Greenspan

Domestic Equity Funds -- January 2006 Review

If January represents an accurate barometer for the rest of the year, 2006 should be good for domestic stocks, although clouds of uncertainty still remain. Despite continued high energy prices, weak GDP growth in the fourth quarter of 2005, worries over when the Federal Reserve will end its tightening campaign, and a global crisis brewing over Iran's nascent nuclear ambitions, the average U.S. domestic stock fund gained 4.76% during the month.

Small-Caps Living Large

Small-cap funds led the pack in January, with the average small-cap growth portfolio leaping 8.35%. Large-cap value funds posted the lowest average return out of all domestic fund categories, rising 3.05% in comparison. Mid-cap funds fell in the middle. The S&P 500 gained 2.65% for the month.

While many observers have been waiting for large-cap stocks to dominate after six years of underperformance, they may have to wait a bit longer. "Investors have been attracted to growth opportunities," said Rosanne Pane, mutual fund strategist at Standard & Poor's. "The most attractive growth rates are in the small and mid-cap space, with the growth styles leading returns for the month. We believe mid- and small-caps will continue to lead returns over the short term, as recent earnings disappointments have been focused in the large-cap arena."

Standard & Poor's equity analysts estimate that operating earnings for the S&P MidCap 400 and S&P SmallCap 600 indices will advance 19% and 21%, respectively, in 2006. In contrast, the large-cap S&P 500 index is projected to deliver only 11% operating earnings growth this year,

Meet The New Boss

Another major concern for investors lies with the Federal Reserve, which in addition to undergoing a change at the top, has been tightening since June 2004. The Fed Funds rate currently stands at 4.50% following another 25 basis point hike yesterday in Alan Greenspan's final session as Chairman. His successor, Benjamin Bernanke, will chair his first rate-policy meeting in late March. There is a lot of speculation on how much further he will boost rates, if at all.

U.S. GDP gained only 1.1% in the fourth quarter of 2005, the weakest advance in three years. That has led some economists to surmise that the Fed may soon stop hiking. "An additional rate hike at the March meeting is a possibility, but looks increasingly less likely, due to the weaker-than-expected 4Q 2005 real GDP growth," said David Wyss, Standard & Poor's Chief Economist. "We don't think Bernanke will raise rates just to let the markets know that he is in charge."

However, others believe the tepid fourth-quarter numbers reflected a temporary pause, and were not indicative of any sustained economic weakness. Moreover, with inflation rising (core prices rose 2.2% in the fourth quarter of 2005, up from a 1.4% rate in the third quarter), the Fed may need to hikesome more. Standard & Poor's Economics department expects 3.5% growth for real GDP for 2006. In 2005, GDP rose 3.5%, following a 4.2% gain in 2004.

The Fed itself has stated that while core inflation has remained relatively low, "some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."

Standard & Poor's believes the Fed Funds rate will finish the year at 4.75%.

Iran's Nuclear Gambit

Energy prices are likely to overhang any discussions of market performance for the remainder of the year. Standard & Poor's believes energy prices will remain high on geopolitical tensions and low spare production capacity as a result of increased demand. Indeed, crude prices are nudging the $70 level, amidst news of unrest in oil-rich Nigeria and the threat of a nuclear stand-off with Iran, the second largest petroleum producer in OPEC.

"The oil markets appears very nervous about the Iranian situation," said Ed Maran, managing director at Thornburg Investment Management. "Iran's production is essential for meeting world demand. There is not enough excess capacity within OPEC to make up for the lost supply if Iran were to stop selling oil."

Maran added that in the extremely remote event of a full-scale war against Iran, "it is likely that in addition to ceasing oil exports, Iran would also seek to obstruct other countries from exporting through the Straits of Hormuz. The short-term impact on oil prices of such an event would be quite dramatic, probably driving oil prices much higher than $100."

Standard & Poor's has a $59 year-end 2006 price target on WTI oil.

Fund Investment Style

January 2006 Average Returns* (%)

Large-Cap Growth

+3.13

Large-Cap Value

+3.05

Large-Cap Blend

+3.23

Mid-Cap Growth

+6.22

Mid-Cap Value

+4.67

Mid-Cap Blend

+5.27

Small-Cap Growth

+8.35

Small-Cap Value

+7.32

Small-Cap Blend

+7.37

All-Cap Growth

+4.86

All-Cap Value

+4.26

Domestic Equity Funds (excluding sector and balanced funds)

+4.76

S&P 500-Stock Index +2.65

*Source: Standard & Poor's. Total returns include reinvested dividends. Preliminary data as of 1/31/06.

InvestmentAdvisor.com has more mutual fund news from Standard & Poor's available here.
Reprints Discuss this story
This is where the comments go.