An uncertain future for equities

June 29, 2006 05:22 AM

Traders and analysts’ forecasts run the gamut for the remainder of 2006, but they agree on a few common themes: Active traders will fair better than the individual investor, technicals appear more bullish than fundamentals, and navigating sectors may be a better approach than picking broad market indexes. Find defensive stocks that churn out decent earnings in strong performing sectors and you may associate 2006 with the year you outsmart equities. Sounds easy, right? Maybe in years past, but with 2006’s hosts of turning points, including an inverted yield curve, numerous unfolding geopolitical situations and a new interest rate landscape, the trader has more than the normal set of factors to decipher.

YIELD CURVE CONUNDRUM

One of the more popularly debated dynamics for this year’s stock market has been the inverted yield curve. Just how much and how long will it invert and does it mean a recession is looming? The short answer according to William Hornbarger, chief fixed income strategist with A.G. Edwards, is not much, not long and no. In mid December, Hornbarger pointed out the yield curve only inverted three days in the last week of December and only one day in January. “We should remember that while it is true that an inverted yield curve has led to recessions, it is important to remember that it is also true that the yield curve has flattened significantly at other times and not led to a recession,” he says.

Similar to what former Federal Reserve Chairman Alan Greenspan has noted, Hornbarger reminds us that while inverted yield curves came before each of the last four recessions, the yield curve also narrowed sharply between 1992 and 1994 and in the following years the economy entered its longest post war expansion. For an inverted e consistent yield curve to be precursor to a recession, Hornbarger explains it would need to be inverted further, there would need to be inversions in various areas, (see “Comparative yield curves,“ below) and the yield curve would need to be inverted for a longer time frame. “It would have to last for a period of time. Not two or three days, but three to six months,” he says.

Hornbarger also reminds investors and traders the yield curve is only one of 10 leading economic indicators. And as for predictions on where the yield curve is headed, he says he is not looking for a sustained inversion. “It would go further if the Fed continued to raise interest rates and energy prices were to rise, which we are watching closely,” Hornbarger says.

However, as of late January A.G. Edwards strategists were predicting oil prices would stabilize and the Fed would stop its rate hike cycle by the spring with Fed Funds not surpassing 4.75%. On Alan Greenspan’s last day in office he not only pushed through one more short term interest rate hike to 4.5%, he also signaled that the series of rate increase was nearing an end. A.G. Edwards equity strategists believe the stock market will see contained inflation and the economy in 2006 will be healthy but will experience slower economic growth than last year. This rather positive forecast also stems from A.G. Edward strategists’ outlook for strong corporate earnings growth this year.

Other analysts share this same viewpoint. Joseph Parnes, editor and publisher of the Shortex Market Letter, explains that besides the Fed’s reaction to oil prices as a telling tale of this year’s stock market, whether or not companies produce strong earnings numbers will be the catalyst determining how much the market can climb. Parnes, who says the Dow Jones Industrial Average (DJIA) will again challenge 11,000 this year, predicts corporate earnings will average 13% for 2006.

However, analysts opinions do differ on just how well corporate earnings look so far. Some point to the numerous high-profile companies that missed earnings estimates as a hurdle that will be hard to get over. In December, companies including Citigroup, GE, Intel and even Yahoo missed earnings targets and only weeks later, in late January, Google announced it missed its earnings estimates for the first time in six quarters. Other analysts, however, say that if you look at the big picture, earnings are doing just fine. On Jan. 30, with approximately 48% of companies in the S&P 500 reporting, A.G. Edwards reported earnings are up more than 17% on a market-cap weighted basis. Of those reporting, 63% came in ahead of estimates while less than 20% fell short of expectations.

A YEAR OF SECTORS

Besides recommending traders keep a close eye on earnings, many traders and analysts agree 2006 is the year to carefully observe which sectors are set up to outperform. Analysts suggest traders look to market sectors instead of focusing on broad indexes.

For instance, Bo Yoder, publisher of the 5MinuteInvestor.com newsletters, does not expect the stock market to perform well in 2006 as a whole, but says with several different forces changing this year, like the dollar beginning to reverse and interest rates lowering, numerous sectors in the stock market will be competing against one another.

“This offers a great opportunity for positive trend followers or swing traders,” Yoder says, adding that while this year may be good for the active trader, the individual investor with positions in broader indexes may experience a rougher ride. As for which sectors he favors this year, Yoder says, “I expect to see a lot of money flowing out of the Dow and going back to the tech sector,” adding that technology stocks that performed well in the past are expected to rebound; like stocks such as Applied Materials. He explains, “Traders may want to look for stocks that already had their day in the sun,” adding that this could be an edge for the active trader in 2006.

Parnes agrees technology may be the way to go. “I expect to see a sort of augmented leadership in the tech sector, especially semiconductors. There is a lot of appetite for electronics,” he says.

Jim Wyckoff, editor of Trends in Futures, a Futures Magazine Group publication, forecasts 2006 as less than exciting for bulls. He predicts this year’s stock market will bring choppy trading range markets. “I expect the stock market to trend slightly higher, but I do not expect that we will experience any kind of strong bull market,” he says. Wyckoff’s general forecast for the year is to see the S&P 500 range between 1200 and 1350. As for picks for sectors in 2006, Wyckoff expects to see some momentum in communication stocks and possibly even entertainment stocks. He says one angle to examine is what he calls “recession proof” stocks. For example, he believes recreational property fits this bill. Wyckoff explains that individuals that own recreational property — for example a lake house — make more money than the average household and owners of the recreational property will make cuts to their budgets in other areas before giving up their vacation homes.

MANAGING UNCERTAINTY

With predictions of choppy, sideways trading markets, what are traders hunting out a trend suppose to do? Wyckoff reminds traders “hope” is a bad word in trading and particularly in the type of trading environment predicted for this year’s stock market. “If a trendline is broken, this is a wake up call,” Wyckoff explains. “Don’t ignore early trend changes. If a daily trend is broken look at the weekly and monthly charts. It may be a sign of a choppy trend or it could signal a fresh downturn and could mean there might be rough sailing the rest of the year.”

Navigating choppy markets is not easy and technical traders looking back at historical data say they can make sense of where this year’s market is headed. Eric Hadik, president of InsiideTrack.com, whose trading approach is mainly cyclical, says there is a four year cycle that is coming into play in 2006. He measures consistent cycles and projects that distance into the future. For 2006, he forecasts a final upswing in stock indexes through April, which will be followed by a multi-year down swing.

Hadik explains the stock market has seen a series of four-year lows going back to 1974. He also sees the stock market completing the next phase of an eight year cycle where markets experienced lows in 1974, 1982, 1990 and 1998. Hadik says because of the direction and pattern of the underlying cycles he expects the market to flip and is looking for a high in 2006. Hadik explains the time frame from late March to early April has the highest probability for a major peak. In addition, a high in late March or early April would complete or continue numerous other cycles, including a 55-week cycle connecting the last three highs and a 24- to 25- week cycle connecting the last five lows, both in the DJIA. Late March will be the six year anniversary of the 2000 peaks in the S&P 500 and the Nasdaq 100; the DJIA peaked in January 2000. Hadik’s ideal upside targets for this three-year plus advance are 11,320 to 11,400 for the DJIA, 1320- 1330 for the S&P and 1840 to 1875 for the Nasdaq 100.

Parnes’ view for the near future is bullish. In his Jan. 25 newsletter he notes the market is positioning itself for the fourth year of a bull market started in October 2002. His newsletter explains the mere fact that gurus, financial media, and money managers are advising the public of sector rotations into holding/taking positions in blue chips with dividend paying issues is indicative that the market blowups are a common phenomenon in the second half cycle of the present bull market. The market may surprise investors by not matching its historical length of a bull market of three and a half years and may in fact repeat the bull market of 1995.

Parnes provides several reasons for why the market plunged in mid- January. He says the market was jittery from earnings not being as strong as first predicted; it was a busy month for options expirations, the market already was beginning a slide and shortly before there were problems in the Japanese Nikkei. “A temporary drop is actually a good thing for the market. Otherwise traders and investors get complacent,” Parnes explains.

Carla M. Bauch is a freelance writer in Chicago.

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