Market bulls are itching to run. They say U.S. stock indexes will not only hit a new high over the next 12 months but also will break their all-time record of five years ago, the peak of the longest-running bull market in history. U.S. business, the bulls argue, will clock in its fourth straight year of strong profit growth, and the economy will grow at a robust clip of 3% or more. Oil prices that reached $70 a barrel this summer will ebb, and inflation worrywarts will be silenced, at least for now. Oh, and the bottom won't fall out of the housing market, either.
Sound far-fetched? Maybe it isn't. If the woes of the auto and airline industries, a Category 4 hurricane, surging oil prices, and increasingly indebted consumers haven't yet derailed the markets, what on earth will? Even a dozen Federal Reserve interest rate hikes since mid-2004 haven't put the kibosh on the economy, which grew at a stronger-than-expected 4.3% rate in the third quarter. Sure, the markets have struggled to process often conflicting signals and, as a result, have been stuck in a narrow trading band for two years. So how can the bulls be so sanguine? "Everyone complains about the stock market going sideways, but sideways is in fact an incredible victory," says Ronald P. O'Hanley, vice-chairman of Pittsburgh-based Mellon Financial Corp. (MEL )
Good point. Thanks to the recent rally, the Standard & Poor's 500-stock index and the NASDAQ Composite Index were up 4% and 3.7%, respectively, through Dec. 9, although the momentum was barely enough to push the Dow Jones industrials into positive territory. Yet even that lackluster outcome is seen as a harbinger of good returns. With the S&P trading at a price-earnings ratio of about 16 based on estimated 2006 earnings, many investment pros think the market is undervalued. "We're bullish," says David S. Spika, an investment strategist at Westwood Holdings Group (WHG ) in Dallas. "The market is relatively cheap."
Spika has plenty of company among the Wall Street strategists we polled for BusinessWeek's 34th yearend investment outlook. The consensus pegs the Dow closing above 11,500 next year, the S&P at 1,347, and the NASDAQ Composite at 2,428 -- roughly 7% gains from here. Our forecasters say they're optimistic because two major headwinds for equities -- rate hikes and oil price spikes -- look to be easing off. As always, an important driver in the stock market will be profits, and they're still holding up well, too. By yearend, S&P 500 stocks will have reported about $77 in operating earnings per share -- a 13% rise, and the 15th quarter in a row of year-over-year double-digit growth. Howard Silverblatt, an equity-market analyst at S&P, says his group expects an additional 11.4% increase in 2006. "It'll downshift just a little bit," agrees Bob Baur, managing director, Principal Global Investors LLC. "But there's nothing wrong with that. You can't expect 20% profit growth forever."
Companies have been sharing that wealth. In 2005 they spent a record $300 billion on share buybacks and another $200 billion on dividend payments, according to Silverblatt. That trend is expected to stay intact, so dividend-paying stocks are still a good bet.
But next year companies are expected to do more with their cash hoards, which amount to a total of about $635 billion for the companies in the S&P 500. Analysts expect that, either by choice or under pressure from newly emboldened activist investors and hedge funds, many will start spending more of the money. That spending will be directed toward technology, equipment, and business services, and may fund a wave of mergers and acquisitions. "I think this will be more of a company-led expansion instead of one led by consumers," says Lincoln Anderson, chief economist at Boston's LPL Financial Services. A brisk market for deals is forecast to trigger gains in banking, asset management, and brokerages, as well as in airlines, utilities, and software.
Of course, certain developments could spoil the bulls' rosy scenario. The Fed could tighten too much. Energy prices could spike again. Certainly, concerns about housing and consumer spending will persist, especially as bankruptcies rise and real estate starts to cool. As a result, many investment pros suggest avoiding retail and consumer durable stocks. In general, Joseph McAlinden, chief investment officer of the global equity group at Morgan Stanley Investment Management (a self-described taurus antiquitus, or old bull, who expects the market to exceed the all-time high reached in the year 2000) still suggests caution. He anticipates a 10% to 15% correction sometime in the second or third quarter and then a surge. "[Stick to] higher-quality companies that are less likely to have earnings clobbered during a downdraft," he says, such as General Electric and defensive stocks in the pharmaceutical and consumer staples industries.
In fact, plenty of market mavens expect such large-cap stocks to do better after being left in the dust by small caps for six years. Wayne C. Stevens, chief investment officer of Chicago's Dearborn Partners LLC, says large caps start to perform better when real returns on 90-day Treasury bills reach 2%. (They were negative until October, 2004.) "We've just hit the inflection point," he says.
UNEASE ON MAIN STREET
Growth stocks, too, are expected to start outperforming value stocks. Tech could likely be the big winner. Richard H. Driehaus, chief investment officer of Chicago's Driehaus Capital Management Inc., has doubled his stake in tech stocks in the past six months, to 20% of the Driehaus Small Cap Growth portfolio. He favors Net advertising, sales, and infrastructure companies, such as 24/7 Real Media (TFSM ), Getty Images (GYI ), Digital River (DRIV ), and Google (GOOG ).
Unlike the pros, most ordinary investors are downbeat. Many are worried about their paychecks, the value of their homes, and their stock portfolios. In fact, they're so glum that, according to Citigroup Inc.'s (C ) Panic/Euphoria model for consumer sentiment is at its most pessimistic since 1994. If renowned stock guru Sir John Templeton was right in saying that bull markets are born of such pessimism, the 2006 stock market outlook may indeed turn out rosier than it looks.
By Mara Der Hovanesian