We Look for Modest Gains in 2006

The economy and corporate profits are strong, and valuations appear attractive. In our view, quality should win out

By Joseph Lisanti

Looking back over the past five years, investors in large-cap stocks have had little to cheer about. The average annual price change for the S&P 500 has been negative, and growth stocks in the index have fared even worse than the benchmark.

This mediocre performance comes at a time when corporate earnings have generally risen. Operating earnings on the S&P 500 rose from 56.13 in 2000 to an estimated 76.80 in 2005, a gain of 36.8%. And that overall gain came despite a 31% decline in operating earnings in 2001.

One way to understand the anemic performance of large-cap stocks in the past half decade is to see it as a reaction to the huge advance in the bubble years of the mid-1990s. From the end of 1994 through 1999, the S&P 500 rose 220%, or 3.5 times the growth of operating earnings in that period.

Things even out a bit if you take a somewhat longer view. Though the S&P 500's compound annual change for the five years ended Nov. 30, 2005 is -1.02%, that figure for the 10 years ended on the same date is 7.5%.

For 2006, we see the S&P 500's total return at 8.5% as the economy and corporate profits continue strong. Specifically, Standard & Poor's economists expect the real gross domestic product in the U.S. to increase 3.4% in 2006. We see inflation, measured by the consumer price index (CPI), remaining muted at 2.4% and core CPI, which excludes volatile food and energy prices, at 2.3% for the coming year. We think the projected $200 billion likely to be spent on rebuilding efforts in the wake of Hurricane Katrina will contribute to growth in the first half of 2006.

Corporate profits should continue to rise, albeit at a somewhat slower pace next year. Aggregating Standard & Poor's analysts' earnings estimates, we project that operating profits on the S&P 500 will advance 11.5% to a record 85.60.

We expect that a larger part of those profits will benefit shareholders via dividends and stock buybacks. Through Dec. 7, Standard & Poor's logged 300 dividend increases by companies in the "500" this year. As a result, we now expect dividends on the index to total 22.10 in 2005. With the payout ratio of the "500" low by historical standards, we see room for additional dividend increases in 2006. For next year, we project S&P 500 dividends will total 24.50, a 10.9% advance.

Cash on the balance sheets of nonfinancial companies in the S&P 500 hit another record in November, at $638 billion. This has enabled companies to increase their share buyback programs. In years past, some companies used buybacks to offset shares issued in conjunction with exercised options. Now that options have to be expensed, we are seeing less of this activity, and buybacks are actually reducing shares outstanding. Over the 12 months ended Sept. 30, 61 issues in the S&P 500 have lowered their share count by at least 4%. We think this has positive implications for per-share earnings and, therefore, stock prices.

In our view, the S&P 500 is attractive at a current multiple of 16.5 times our estimate of 2005 operating earnings. That compares favorably with the 19.8 average p-e ratio on estimated operating earnings for the period 1988 through 2004. In addition, relative to bond yields, the current 6% earnings yield of the index (the inverse of the p-e) suggests to us that the market is undervalued.

We expect that the yield of the 10-year Treasury will rise slightly, reaching close to 5.2% in the third quarter of 2006. This should come as the Federal Reserve's efforts to quell any incipient inflation begin to affect longer-dated debt instruments. In our view, the Fed is likely to halt its current round of tightening with the fed funds rate at 4.75%, perhaps in the first quarter of 2006. We also see oil averaging $56 a barrel next year, providing some degree of price stability.

One risk to our forecast is that the Fed could continue tightening short-term rates to the point where the economy slides into recession. However, given the measured pace at which the Federal Reserve has been moving, we consider this scenario highly unlikely. A less quantifiable risk involves energy. Should the Gulf of Mexico suffer another hurricane season like the last one, damage to the energy infrastructure could cause oil prices to spike.

We think it is an appropriate time to consider higher-quality stocks. Recently, stocks with above-average Standard & Poor's quality rankings have not performed as well as lesser-quality issues. Our research suggests that such underperformance of high-quality stocks (those above the ranking of B+) is cyclical, and likely to revert to a more normal pattern before long. Over longer time periods, stocks that have above-average growth and stability of earnings and dividends for the preceding 10-year period have tended to outperform.

We see the S&P 500 ending 2006 at 1360, for a 6.7% advance over the 1275 we now forecast for the end of this year. The projected advance is modest in part because the bull move that began in October 2002 is getting a bit long in the tooth. Furthermore, corporate profits, though growing, are doing so at a slower pace. Nevertheless, the advance we see is not far below the 7.6% average annual gain that the S&P 500 has posted since 1929.

We recommend that you keep 45% of your investment assets in domestic stocks, 20% in foreign equities, 20% in short-to-intermediate-term debt instruments, and 15% in cash. Among sectors of the market, we currently favor consumer staples, health care, and financials.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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