What If…’ Investors Play the Long Odds

first_imgThe stock market is off to a flying start in 2006, and the experts are busy crossing their fingers, hoping their predictions come true. Some of those predictions, such as weakness in the dollar and a slowdown in the housing market, already seem to be taking place. But investors also need to focus on some of the potential surprises for this year call them the what if’ investing scenarios even if there’s a smaller possibility that these will actually happen. The reason: Big profits come from arriving early to the next trend, before others get on the bandwagon. Buying before the good news, and selling investments before the bad news already is reflected in the price of a stock or bond, is the goal of every investor. That’s why many savvy investors see value in sifting through the potential surprises for 2006, to see which have a decent chance of taking place. For example, many stock strategists predict a slowdown in the growth rate of the U.S. economy, as the effects of a string of interestrate increases by the Federal Reserve are felt. This could spur the Federal Reserve to stop raising interest rates. 1 Muscular Economy But James Paulsen, chief investment strategist at Wells Capital Management, argues that the economy’s revival, though long in the tooth, could continue this year, with the U.S. gross domestic product rising an impressive 4%. Good news for the entire stock market, right? Not really. If the U.S. economy continues to expand at a rapid pace, the threat of inflation will hang over the stock market throughout the year and this could hold back the overall market, much as it did in 2005. Mr. Paulsen notes that the Fed hasn’t been able to push yields on bonds which affect rates on many mortgages and other loans much higher in the past year, and may continue to raise short-term rates, perhaps after a pause in the spring, until market rates are considerably higher and the economy finally slows. All this could spell malaise for safe, “defensive” stocks, such as big banks including Citigroup (C) and J.P. Morgan Chase (JPM), which appear quite cheap but often are overlooked when the economy is an upswing. And it could mean more good times for small-cap and cyclical stocks, which led the market in 2005 and usually do best when the economy is an upswing. So far, his prediction has been borne out the Russell 2000, an index of smaller stocks, is up 5.2% so far in 2006, compared with a 2.3% gain for the Dow Jones Industrial Average. “Due to Fed tightening, most investors forecast a 2006 slowdown, which implies the Fed is close to stopping tightening, which should allow the stock market to rise further led by large-cap, defensive” stocks, he says. “The surprise might be that Fed tightening thus far is really not that restrictive, and thus the economy keeps rocking and rolling.” Byron R. Wien, chief investment strategist at hedge fund Pequot Capital Management who publishes an annual list of surprises, also guesses that new Fed Chairman Ben Bernanke could keep raising interest rates, hurting banks’ shares. Others say continued rate boosts by the Fed will send bond prices much lower. Bond prices have held up well in the past few years, with prices of riskier bonds such as junk bonds doing especially well. But so many companies with lower ratings have sold bonds in recent years that some say investors aren’t sufficiently worried about repayment problems from more companies in 2006. Even if the economy continues to grow, lower-quality companies may begin to have trouble paying back debts. 2 Exuberant Consumers Another surprise could be if the U.S. consumer, laden with debt, holds up well, helping retail and other consumer-oriented stocks in the process. Many expect it to be a harder year for consumers, in part because a weaker housing market and higher interest rates will make it more difficult for homeowners to refinance their mortgages and extract equity from their homes. But if workers finally begin to extract bigger paychecks from employers and unemployment stays low, the balance sheets of consumers could be strengthened, helping big retailing and consumer stocks like InterContinental Hotels Group of London (trading in the U.S. under the symbol IHG), Federated Depar tment Stores (FD) and Car nival Corp. (CCL). With the state of the consumer up in the air, some analysts recommend shares of Darden Restaurants (DRI), the parent of casual dining restaurants such as Olive Garden and Red Lobster, that has seen growing business lately and is expected to expand earnings by 17% in the next year. But the stock trades at a reasonable 17 times next year’s expected earnings, and analysts have been raising their estimates lately. 3 Gold Gives It Up Mr. Wien says that despite the recent ardor among investors for gold and gold-related shares, this excitement could subside in 2006, surprising investors who have shifted into the commodity. The drop could come as investors stop worrying about inflation and they switch to other investments as gold stops rising. 4 Iranian Nukes; Protectionism Some analysts, including Tobias Levkovich, chief U.S. equity strategist at Citigroup, worry about a move by Iran to accelerate its nuclear program. So far, the government of Iran has showed no evidence that it will back down from its nuclear program. Most investors have ignored the conflict. But if a military showdown takes place with the U.S., Europe or Israel it could rock the U.S. market, and remind investors of the risks in global investing. Mr. Levkovich also says a surprise could come from a surge of protectionist sentiment in Washington, which could hurt the markets. Some think this could be spurred by continued cheap imports, and the difficulties that U.S. manufacturers are having. 5 Oil Slides to $45 a Barrel A possible piece of good news, at least for most consumers: Mr. Paulsen suggests that oil prices could fall, and oil stocks do poorly, as it becomes clear that there is no looming shortage of oil. Consumers also could shift their habits to use less energy, by driving smaller automobiles and turning down the thermostat, perturbed over sky-high energy bills. “Crude prices may decline to the mid-$40s rather than rising above $70,” says Mr. Paulsen. “The secular oil-shortage story has elements of truth, but crude prices are ahead of themselves based on this story…everyone is caught up with the idea [that] oil stocks are the place to be.” AD Quality Auto 360p 720p 1080p Top articles1/5READ MOREGift Box shows no rust in San Antonio Stakes win at Santa Anita160Want local news?Sign up for the Localist and stay informed Something went wrong. 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