First, a brief recap of 2005. The overall equity market is up around 4% year-to-date through December 5, 2005, led by strong performance from the energy sector. The worst performing sectors have been consumer discretionary and telecommunications which both have declined approximately 5%. Meanwhile year over year earnings per share (EPS) growth for the S&P 500 is expected to approach 13–15%. With EPS growth over three times as strong as stock price appreciation, the overall P/E multiple of the S&P 500 has fallen for most of the year and is currently at 16x forward earnings estimates. Generally speaking, valuations now appear reasonable.
Earnings should continue to grow in 2006, albeit at a lower rate than 2005. That is one reason the stock market has advanced far less in 2005 than earnings growth might warrant. Investors are fearful that earnings growth is slowing. Additionally, the devastating hurricanes, the spike in oil prices, and the frustrating situation in Iraq has had a dampening effect on overall investor sentiment.
With this as a backdrop, we are looking toward different catalysts for the equity market in 2006. Below we outline three predictions for 2006.
#1 – Mergers and Acquisitions will accelerate and become the driving force for a healthy equity market. According to the Wall Street Journal, “Companies in the Standard & Poor's 500-stock index have accumulated more than $650 billion in cash, up from $329 billion five years ago, and almost a third of the nonfinancial stocks in the S&P 500 have more cash than debt.” Boards of Directors, institutional shareholders, and activist-oriented hedge funds are all putting increasing pressure on companies to improve performance. With this mountain of cash and a shortage of attractive growth opportunities, corporate America is ripe for massive consolidation. Underfunded pension liabilities and burdensome retiree health care costs should also motivate companies to look for merger partners. Our sense is that M & A activity will emerge as the dominant theme for 2006. Industries ripe for massive consolidation include health care, manufacturing, and financial services.
#2 – The fears of accelerating inflation will subside paving the way for an end to Fed tightening. Contrary to overblown media-driven fears, energy prices are not the driving force of inflation. The most important determinant of future inflation is the trend in labor costs, and wages in this country are under intense pressure from the deflationary forces of globalization.
U.S. manufacturing has finally realized that it can not be competitive globally while paying wages and benefits that are ten times higher than what workers are paid in the rest of the world. Union contract negotiations will increasingly focus on reducing wage rates as well as benefits, as we have already witnessed in the auto industry.
These trends are hugely deflationary and irreversible. This situation is not limited to manufacturing. Global pressures will increasingly impact most other industries and sectors as emerging markets and economies continue to develop.
#3 - The Big Kahuna. We think stock prices are poised to move higher in 2006. The three components of our bullish view are reasonable valuation, accelerating M&A activity, and an end to Fed interest rate hikes. If we are correct then stocks could advance 8-10%, with a double digit gain not out of the realm of possibility. However, prudent portfolio management requires a “Plan B Mentality”, as the unexpected often occurs. Our sense is that the risks to our bullish view are mostly on the geopolitical front. First, we continue to live with the threat of a terrorist incident. We are also increasingly concerned regarding potential environmental disaster in China that could disrupt the rapid economic growth in that region. These potential events could shock the global economy, causing an inflation scare or the risk of recession. Unfortunately, these events are virtually impossible to predict. Nevertheless, our Plan B involves a more defensive stance, with a likely rotation into more conservative, stable growth sectors like consumer staples.
Barring these unforeseen events, I think the overall equity market could do reasonably well in 2006. At the same time, while we do not expect to execute Plan B, it remains an important aspect of our risk management strategy. This reminds me of the pilot who tried to explain a mechanical problem to an impatient group of passengers waiting to take off. He said, “It’s better to be on the ground wishing you were up in the air then in the air wishing you were on the ground.”
Our strategy going into 2006 will be a continuation of what has worked well in 2005. We will continue to focus on identifying undervalued, high quality stocks across all sectors, with a bias toward health care, industrials, and financials.
We look forward to sharing our views on the market and other topical issues throughout the New Year. In the meantime, we would like to thank all of you for your support and we wish you a joyful holiday season.
