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Stocks Could End the Year Higher
Market Forces May Cause Mid-Year Shift
 By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
January 25, 2006
The following article has been issued by our parent Frank Russell Company in Tacoma, Washington and is referring specifically to the US market unless otherwise stated.
By the end of the year I believe the US stock market could be as much as 10% higher than it was at the end of 2005. But the road reaching that point is likely to be filled with valleys as well as hills.
Certainly, 2006 started on a good note with the broad US equity market gaining 3.4%, as measured by the Russell 3000® Index though Jan. 13. Much of that confidence likely was due to investors looking ahead to the end of the Federal Reserve's interest-rate increases.
The S&P/TSX Composite Index has also performed solidly in early 2006, gaining 5.3% (as of January 27).
Investors' confidence was in contrast with the threat of higher rates that hung over the markets for much of the past 18 months. So much so that many analysts feared that the US Federal Reserve would continue boosting rates and might force the economy into recession.
But, with the US Federal Reserve Board widely expected to stop raising rates in the next couple of months, the threat now is being taken off the table.
The US broad stock market is likely to rise again should the Fed indeed take the step in the next couple of months and stop raising rates. Investors are likely then to become more firmly convinced that recession no longer looms as a threat on the horizon.
But, after those gains, as the year unfolds, we could see pressure on consumers resulting in a slowdown in the equity markets.
Factors With Impact
Consumer spending — a major ingredient in the recent US economic recovery — might be curbed by falling house prices, the delayed impact of higher short-term interest rates, climbing oil and other energy costs and an upward push in inflation.
The pressure on consumers might come from several sources.
One might be a reduction in housing demand, along with US Federal regulators clamping down on high-risk mortgages. Such a move might reduce the ability of consumers to finance their expenditures by borrowing on home equity.
As a result, for the first time in five years I expect we might see no appreciable increase in home equity through 2006, and, should this take place, it could have a dampening effect on consumer consumption.
Oil prices also might continue to edge ever higher.
Growth in China, which continues to assert a larger influence on marginal global demand, is likely to be a strong driver of higher oil prices. Other commodity prices might continue their upward trends as well.
At the same time, I believe that federal deficits and an end to rising short-term interest rates might stop the rising exchange value of the US dollar. Although this may not be significant early in 2006, as the year progresses a weaker dollar and sustained demand for commodities might start putting upward pressure on import prices, a trend that could ignite inflationary forces in the domestic economy.
Even if the US Federal Reserve does not respond by raising rates, nominal rates might increase, driven by inflationary realizations and expectations. The 10-year Treasury Bond, for example, at 4.45% on January 25, might be yielding 5% by the time 2006 is over.
Also, should house prices fall, consumers might be less able to borrow money on their homes, particularly should new federal regulations make non-traditional mortgage lending less likely.
As a result, stocks might plateau during the second half of 2006. I do not see them falling strongly, however, and many of the gains made during the first part of the year are likely to be retained.
But later in the year the forces that caused the market to shift into idle in the first 10 months of 2005 might reassert themselves. These forces also might increase pressure on consumers who might be forced to cut back on their spending as a result.
So around the middle of the year I expect we might see earnings comparisons suffering, consumer expectations starting to wane and stock price momentum starting to suffer. Combined, it's possible that they are likely to put a damper on the markets, but are not likely to send stocks tumbling.
My Best Estimate
Consequently, my forecast is that, over the course of the year:
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- Stocks will perform better than bonds and real estate investment securities
- Foreign stocks will fare better than US equities
- Growth will beat value stocks and large will beat small
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Whatever happens, diversification among asset classes is a prudent investment strategy.
Above all, it may be unwise to decrease your exposure to stocks below your target levels based on what occurred last year rather than on what could occur this year.
Opinion and Forward Looking disclaimer
The information and any statistical data contained herein have been obtained from sources which we believe to be reliable but we do not represent they are accurate or complete and they should not be relied upon as such. In addition, this report contains forward-looking statements about the market, expected performance and condition. Forward-looking statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as "expects", "anticipates", "plans", "believes", "estimates" or negative versions thereof and similar expressions. Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in any forward-looking statements made.
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