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This Year Could Be a Lot Like Last Year

Times Staff Writer

In hindsight, many investors now know what they should have done a year ago: Put more money in foreign stocks. Be wary of sinking too much into real estate. Expect positive, but muted, returns on U.S. stocks. And stop worrying about long-term interest rates.

What a difference a year doesn’t make: Most of that advice applies to 2006 as well -- that is, if you buy into the conventional wisdom on Wall Street.

Many professional investment strategists are going with the flow, figuring there is a very good chance that the major economic and market trends of 2005 can continue.

Which is to say the pros don’t see disaster looming. But of course, they almost never do. Wall Street is by nature an optimistic place -- or at least, it’s optimistic that you will stay optimistic and thus willing to invest your money.

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The truth is, disaster usually isn’t a good bet anyway. There always are plenty of things to worry about. But the economy’s normal state is one of growth. Recessions are relative rarities.

And largely because the economy is mostly advancing, the stock market’s normal state is one of rising share prices, in the aggregate. Bear markets are the exception, not the rule.

With that as a foreword, here’s a review of three main sectors of financial markets in 2005, along with a look at their 2006 prospects:

* U.S. stocks: Big-name stocks were duds in 2005, for a second straight year. Smaller stocks performed much better and beat their big-name brethren for a sixth straight year.

So if you expect the economy (and corporate earnings) to keep growing in 2006, and you plan to stay invested in the U.S. stock market, one major question is how to divide your bet between big-capitalization shares and smaller-capitalization shares.

The easy argument for the big stocks is, they’ve suffered enough already. If the Federal Reserve stops tightening credit this year, as most on Wall Street expect, that could be the long-awaited spark for a blue-chip renaissance.

The Dow Jones industrial average ended Friday at 10,717.50, down 0.6% for the year. Including dividends, the index’s total return was about 1.7%.

The broader measure of blue chips, the Standard & Poor’s 500 index, gained 3%, and 4.9% with dividends.

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By contrast, S&P;'s index of 600 smaller stocks was up 6.7%, and 7.7% with dividends. And since the end of 2000, the S&P; small-stock index has gained about 11% a year, trouncing the 0.5% average annual gain of the S&P; 500.

The performance data suggest that big-name stocks are overdue to play catch-up, and that smaller stocks are overdue to take a break.

Some year, that’s going to happen. But will it be in 2006?

It’s hard to find anyone on Wall Street who doesn’t think that many classic blue chips are priced attractively -- maybe not dirt-cheap but not expensive, either.

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Standard & Poor’s calculates that the average S&P; 500 stock is priced at 15 times estimated 2006 operating earnings per share. That is a notch below the historical average price-to-earnings ratio of 16.1 since 1960, according to Tobias Levkovich, investment strategist at Citigroup Global Markets in New York.

He expects S&P; 500 earnings to rise 9% in 2006, which would be down from the 13% growth rate estimated for 2005. Earnings may be slowing, but with blue-chip stocks trading below their historical average P/E ratio, Levkovich figures the S&P; 500 index still could advance 12% this year, to end the year near 1,400.

For what it’s worth, many of his compatriots on Wall Street are in the same ballpark.

Like the trend for most of this decade, however, earnings of smaller companies are expected to grow faster than blue-chip earnings in 2006. Sam Stovall, investment strategist at S&P;, figures small-company earnings will rise 19%, on average, this year.

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But what if something goes very wrong -- the economy stumbles, housing crumbles, energy prices soar anew, or terrorists strike the U.S.? If you think the economic and market risks overall are rising, that’s an argument for tilting more toward struggling big-name stocks.

As Stovall puts it, “Investors usually will gravitate toward higher-quality investments when they become more worried about future prospects.”

If things go really wrong, of course, almost all stocks will sink. But what’s perceived as cheaper should sink less.

* Foreign stocks: They were the place to be in 2005, even amid a strengthening dollar that cut into returns overseas when translated into dollars.

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Japan’s blue-chip Nikkei 225 index soared 40.2% in yen and 22.1% in dollars. The German market gained 27.1% in euros and 11.1% in dollars.

Many emerging markets did even better. The Mexican market was up 44.5% in dollars.

Michael Metz, investment strategist at money manager Oppenheimer Holdings in New York, believes that the central message in the performance of most foreign markets is that investors are betting on continuing economic growth worldwide and improving prospects particularly in Japan and Europe.

Stretched U.S. consumers, Metz says, may have a hard time boosting their spending in 2006, but that should be less of a problem for consumers in Germany, Japan and elsewhere, he says.

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“I think we’re going to see a big pickup in consumption overseas,” Metz said.

What’s more, if China continues its rapid development, that will pull up many other Asian economies and could keep commodity prices high -- helping economies of oil exporters like Mexico.

Don’t underestimate momentum. Asia’s economic success “suggests there’s more to come there,” said Robert Morris, director of equity investments at money manager Lord, Abbett & Co. in Jersey City., N.J.

OK, but two cautionary points: One is that emerging markets, in particular, are notoriously volatile. That means, rather than chase last year’s performance, smart investors might want to wait for a sell-off to move in or to add to their stakes. A sell-off inevitably will come in 2006.

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The second point is that foreign markets, on balance, have beaten U.S. stocks all along in this decade. Could that argue for increasing your U.S. stock investments over foreign?

Metz doesn’t think so. “I think the next few years belong to foreign markets,” he said.

* U.S. bonds/fixed income: Never have so many people agonized over what turned out to be so little.

We’re talking about the effort spent in 2005 worrying about the trend in long-term interest rates. With the Fed consistently raising its benchmark short-term interest rate -- it was 2.25% at the start of 2005 and is now 4.25% -- one would have thought that long-term rates would rise substantially as well.

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One would have been wrong, at least with regard to Treasury bonds. The 10-year Treasury note yield ended Friday at 4.39%. That was up modestly from 4.22% at the end of 2004.

The 25-year T-bond yield actually declined over the year, to 4.54% from 4.83%.

For all the worry, investors in the Pimco Total Return bond mutual fund, the world’s largest, earned about 2.5% for the year. They made money, but they would have earned more in the average stock mutual fund or in a money market fund.

Now, the debate over bonds and interest rates has a whole different tone. If the Fed is nearly done raising rates, does that mean that it might soon begin cutting them? The bond market seems to be signaling as much, because of the “inversion” of rates: The two-year T-note yield, at 4.40% on Friday, now slightly exceeds the 10-year T-note yield.

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Inversions historically have been warnings that the economy would slow significantly, pulling all interest rates down.

If you believe that, it might well be time to lock in long-term bond yields. But given how wrong nearly everyone has been about bonds for the last two years, do you really want to make a big bet on plunging yields?

What if yields rise in 2006 or finish about where they’re beginning? You won’t make much money in bonds. And in the meantime, with the average money market mutual fund paying 3.65% -- and rising -- the reward for just playing it safe in cash isn’t bad at all.

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Tom Petruno can be reached at tom.petruno@latimes.com.


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