Finding the hot markets of 2006

June 30, 2006 12:19 PM

Probably not much to your surprise, the energy sector seems to receive the most fanfare when it comes to hot markets for 2006. Forecasts for crude to reach $67 per barrel by March are easy to find and some say by the beginning of 2006 crude oil could bounce back to $70.

Phil Flynn, energy analyst with Alaron, says the 2006 energy market will be as hot as this year’s. “So hot they will burn your hands,” jokes Flynn. He attributes his bullish forecasts to the U.S. economy continuing to produce strong gross domestic product (GDP) numbers regardless of this year’s hurricane disasters. “While many analysts are equating the recent weak demand period [late October] a result of the storms in the Gulf of Mexico, the truth is that October is a weak demand period anyway. Equating the demand with the storms doesn’t access the whole economic picture,” Flynn explains.

Economic growth, for instance, came in a surprisingly strong 3.8% pace in the third quarter. Despite high energy prices and hurricane damages, consumers and businesses seemed to spend rather briskly. Some analysts predicted that if Katrina and Rita would have missed the United States, GDP expansion for July through September may have been above 4%.

“GDP has been strong month after month. If you take a chart of GDP and a chart of oil demand you will see both increasing at a very strong pace,” Flynn says. As for Flynn’s forecast, he says, “We could test $70 crude oil very shortly, as soon as January. In heating oil, next year I expect to see the market above $2.00 and unleaded gasoline I expect to see at $1.80.” He says between January and September of next year the entire energy sector could once again test all-time highs.

NOT SO HOT STOCKS

Rising crude oil prices does not provide equities much of a rosy outlook, but if you combine this with stimulus factors that appear set to wind down in 2006, the stock market looks less than hot. “We are looking at bottoming prices,” said Barry Ritholtz, chief market strategist with Maxim Group, in early November. “We will see a nice pop for the rest of the year, with increasingly less positive prices for 2006.”

Ritholtz explains that numerous factors would need to come in line for the stock market to perform well next year. He lists the following: oil prices to decrease by $20, salary wages to increase, consumers to start another round of spending, corporate spending to increase, inflation to stay under control, the president to pick himself up from what some label a lame duck term and to have a tax plan approved. “Then we would have a hell of a rally in 2006,” Ritholtz says. “If we only get half of these, 2006 will be a choppy year, if we get none of these 2006 will likely be one for the record books that we try to forget.”

Inflation is probably the number one factor that may hold back stocks next year. “We have had very robust inflation for a couple of years, and it is only recently that Wall Street has now discovered it,” Ritholtz says. He points out it is not just energy prices going up, but everything else as well. “Energy, food, precious metals and construction materials — they are all going up. Corporate healthcare is 15% higher than three years ago. Wherever you look outside of energy, there is inflation,” Ritholtz says. As for a short term stock market forecast, he sees the S&P at 1280 by the end of the year.

The Federal Reserve continues to battle inflation and on Nov. 1 raised the fed funds rate by a quarter of a percentage point, the twelfth consecutive increase since June 2004. Many analysts believe the Fed will raise rates at its final meeting this year and again at the first meeting of 2006. Ritholtz said after the Nov. 1 hike he expects three more Fed hikes and maybe even more. Brian Dolan, director of research for Gain Capital, shares a similar view. “I expect the U.S. tightening cycle to continue into 2006, possibly come to an end in the first quarter, but more likely around the second quarter,” Dolan says.

FOREX FORECAST

Much like the 2006 stock market, the forex market also is at a crossroads. And many traders, including Dolan, expect trade and budget deficits to get the best of the dollar and lead to a not so hot 2006. The monthly trade deficit has increased from $29.8 billion in January 2002 to $59 billion in August, which was just below economists’ forecasts of $59.5 billion. Dolan overall sees the dollar next year as relatively “erratic” and says he expects the dollar to fluctuate around the levels seen in late October. His rational for this is the U.S. interest rate outlook and what he says will be a “consumption retrenchment” on the part of the U.S. consumer as the result of rising energy costs and inflation.

“I expect weaker dollar volatility in 2006, but a sideways trading dollar,” Dolan says. He expects to see fewer cheaper imports in the United States in 2006. “As Europe reduces its disposable income, Europeans will favor Asian imports over U.S. imports,” Dolan explains. But one bright side for traders may be the Japanese yen. Dolan says in terms of general disposable income, Japan is in better shape than the United States. “I expect to see the yen strengthen against the euro and also against the dollar,” Dolan says.

So as for profit making in 2006, crosses against the yen may have the best potential. “With the global economic slowdown the higher yielding currencies like the Australian dollar and the British pound have the most to lose,” Dolan says. He says trades to consider placing on the short side, might include the Australian dollar/yen, the British pound/yen and the New Zealand dollar/yen.

SIZZLING METALS?

A less than hot dollar forecast leads us, without surprise, to a positive outlook for metals. Add strength in the overall commodity cycle and geopolitical tensions, and the precious metals are set for rising prices. Many analysts predict gold to average around $440 per ounce in 2006, but some have even higher expectations. “I expect to see a strong rebound in the first quarter of 2006. I see gold easily reaching $500 in 2006 and silver touching $10 next year, probably in the first quarter,” says David Morgan, metals analyst with Silver-Investor.com. As for the shorter term he does not see gold climbing back above the $475 level without first pulling back to $456.

“However, my forecasts for gold and silver at these lower levels are brief and sharp,” Morgan says. Part of what Morgan bases his positive metal outlook on is more “smart” money moving into the metals, including hedge funds and certified financial planners’ client assets as well as his forecasts for a continued deteriorating dollar. Clif Droke, chief analyst with ClifDroke.com, has a different take. Droke says, “Gold has overshot on the upside and I see a fall back in early 2006.”

He adds that he sees gold coming back into trading ranges seen in late October during the first half of next year. During the first six months of 2006 he sees the low for gold in the $410 to $415 range and the high range to be around $465 to $475. Droke’s reasoning for this prediction is due to the eight year cycle that he says will bottom in September 2006.

GAINS FOR GRAINS?

Demand for energy is sure to play a major role next year in grains’ higher price potential. Take for instance the demand for ethanol. By the end of next year, the number of ethanol plants will rapidly increase and ethanol production is expected to double. Combine this with farmers planting less corn acres due to rising fertilizer costs, along with China’s need to feed its predicted doubling dairy herds, and even with large carryovers, corn may be due for a climb in 2006. “There is more than ample corn to offset any production problems we may have, but we still have to understand pricing on the supply side,” says Tim Hannagan, grains analyst, Alaron. Hannagan describes next year’s summer corn market as “not bullish, but a friendly demand driven market.”

One point to remember, Hannagan says, is that 70% of the feed grain produced in the United States goes to the Asian market. He says the U.S. market will export more feed grain than usual to the Asian markets to feed its increase in dairy herds. Hannagan says he expects that next year China will sell a lot of its old corn to surrounding neighbors at a low price and use better quality U.S. corn for feed for dairy farmers. Hannagan points to an increased demand for U.S. feed, increase demand for Asian feed and a growing demand for ethanol as corn’s main drivers next year. He expects corn to reach $2.34 to $2.45 per bushel.

While most analysts look at wheat as a commodity due for higher prices next year, mainly based on inventory numbers coming down, Hannagan’s picture for wheat is not quite as hot. “Demand for U.S. wheat has been decreasing over the last few years. The United States is the third or fourth port that wheat buyers turn to for high quality wheat,” Hannagan says. As of Oct. 25, only 50% of the winter wheat crop was in good to excellent condition. “We are starting in the hole already. We are off to a bad start. I project going into next year that demand is going to continue to be generally weak,” Hannagan says. He says he cannot predict any appreciable rally in the market and expects that between early November and March the market will pull back to $3.02 to $3.12.

Like corn, soybeans next year will experience a large carryover. But some analysts say the growing demand for protein coupled with the demand for bio-diesel fuel may give soybeans the boost it needs to see higher prices in 2006. “We read that China plans to increase its bio-diesel fuel production six fold by 2008,” Hannagan says. However, Hannagan points out that this year’s hurricane winds have increased the chance of Asian rust, which he says can result in 8% to 15% of soybean production becoming unsuitable for export.

Given the large carryover and an overall outlook for large yields farmers will plant less corn, which means more soybeans. Hannagan expects to see soybeans reach around $6.40 to $6.60 per bushel during the summer months of July and August.

While weather, demand and supply will determine whether next year’s grains make large moves, one additional factor might need to be added to the list — bird flu. Hannagan warns that if a large outbreak occurred, feed demand would take a huge hit pushing down the price of grains, including corn and beans.

Carla M. Bauch is a freelance writer in Chicago.

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