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Down, Then Up, in 2006

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Economic growth will slow a bit; earnings growth will moderate; large-cap will outperform small cap, non-U.S. equities will outperform U.S. equities for the fifth year in a row, and the stock market will have a correction and then resume the bull market.

These are some of the predictions for 2006 that Robert Doll, president and CIO of Merrill Lynch Investment Management, shared with journalists on January 10th at Merrill Lynch’s headquarters in downtown New York. Doll says he expects a double-digit stock market correction in 2006, “10% plus a bit, but not 20%,” to position the market for what he calls “the second half” of the bull market that started in October 2002. “Merrill Lynch is not bearish,” Doll emphasizes, but he says volatility is going to pick up, and a correction would be a normal event; “on average they happen every 18 months,” says Doll, and we haven’t had one since the bull market started, so we are overdue.

Doll expects that higher interest rates and oil prices will weaken consumer spending, though capital spending by corporations, thanks to lots of free cash flow, “remains relatively strong,” and will lead to a U.S. GDP of about 3% for 2006, slightly less than the 2005 GDP of about 3.5%, and the more robust 4.5% GDP in 2004. There is a long lag between the time short-term interest rates rise, and oil prices increase, and the time the consumer feels the pinch, he says, usually in the second year after such increases.

Though the consensus estimate for earnings growth for 2006 is 13%, Doll predicts earnings growth will be closer to the long-term average of 5% to 7%, a number that he believes is more realistic. The basis for his predication? Achieving growth of 13% would mark “an unprecedented four years in a row of double-digit earnings growth.”

As far as equities are concerned, Doll says he expects large-cap stocks to outperform small-cap stocks, and growth to outperform value, “for the first time since 1999,” citing reversion to the mean.

Both growth and large-cap stocks have been underperforming for years, he notes, many large-caps have a free cash flow advantage, and they have exposure to markets in countries outside of the U.S. where GDP is higher and where individual income has gone up substantially. He says non-U.S. equity markets will outperform U.S. equity markets, “for the fifth year in a row,” especially Asia, led by Japan; followed by other select emerging markets; and then by Europe’s equity markets.–Kathleen M. McBride


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