Dueling Fools: 2006 Bear

I can't be as optimistic as my friend Rick. And I hate that. I am a stock investor, too, after all. It's good for my portfolio when stocks, as a whole, head north.

Yet I just can't shake the feeling that we're heading for no better than a sideways market in 2006. Perhaps I'm swayed by Ed Easterling's comprehensive analysis of historical stock market returns. (Easterling, a highly regarded researcher and author of Unexpected Returns, wrote in October that investors should expect no better than 6% annual stock market returns over the long term, well below the historical average of 11%.) Or maybe it's that everyone seems to think the market is going to keep heading higher.

The running of the bulls
Take a look at the most recent BusinessWeek and its annual "Where to Invest?" prognosti-fest. Start with the opening article, which is predictably titled "The Bulls: Pawing and Snorting." Within is your usual bull-market fare: Rising corporate profits; acquisitive, cash-rich companies; moderating interest rates; and normalizing energy prices.

And BusinessWeek isn't the only one. From Forbes and its 2006 investment guide: "Overall, the mood is bullish." Barron's, too, is in on the optimism, with pages of thumbs-up prognostications from analyst contributors. It's as though the entire financial media is assembled outside 11 Wall St. in lower Manhattan -- otherwise known as the home of the New York Stock Exchange -- to give traders, brokers, and executives a rousing ovation: Go, team, go!

Such thunderous applause from all corners cheering the market's advance has me nervous. After all, groupthink has proved to be disastrous throughout financial history. Just ask John J. Raskob, a Depression-era financier who publicly predicted in August 1929 that investors could generate 26% annual returns in the stock market. Whoops.

But I digress. The point is that the unbridled enthusiasm on display in bookstores and newsstands across America appears based on either fuzzy math or wishful thinking. Or, maybe, both.

When P/Es attack
Take corporate earnings, for example. BusinessWeek points out that the S&P 500 is valued at only 16 times next year's earnings. That sounds like a bargain, especially when data provider Barra reports that the market's trailing P/E eclipsed 18.5 through Nov. 30. There's only one problem: Consumers must act to create the growth that the snorting, pawing bulls on the Street are expecting.

That's right -- approximately 70% of the spending that fuels corporate profits comes from the pockets of Joe and Jane Oddlot. But they're running a little short lately. Indeed, in September, I made the case for more conservative portfolio management in large part because the national savings rate ran negative during July for the just the second time in 46 years. (It has dropped from an average of 4.5% in 1987 to roughly 1% today.)

Spend today what you could save for tomorrow
There's also no sign that consumers will improve their balance sheets anytime soon. According to economist Stefan M.I. Karlsson, the decline in personal savings has come entirely from the housing sector. All told, he estimates that debt has risen from an average of 77% of disposable income at the beginning of former Fed Chairman Alan Greenspan's rein to approximately 121% today. Mortgage debt, he says, is up from 51% to 91% of disposable income.

It gets worse. The Mortgage Bankers Association now says that interest-only loans accounted for 23% of all U.S. mortgages from January to June of this year, up from 17% during 2004. Even more astounding is a Bloomberg report that says Countrywide Financial (NYSE: CFC  ) made $27 billion in interest-only loans during Q3. That was up 50%.

This is a stark imbalance that could produce steep consequences. And I'm not the only one saying so. No less than the Federal Reserve said last week that it was concerned that these loans were being offered to a "wider spectrum of borrowers." Probable translation: To folks who will retire broke if they don't stop spending like Imelda Marcos at Nine West.

Don't be so surprised that the Fed is concerned. Less disposable income equals fewer dollars available for shopping and, yes, investing. Yet the market needs capital to fuel demand, and demand to fuel returns. Welcome to Economics 101.

Feeding the Fed; hurting the herd
Look, I'm not an economist. I just know when to listen to one. And the right ones are saying that the economic conditions don't indicate a broad stock-market rally. I tend to believe them.

But I also think it's worth listening to proven investors -- like Bill Gross of PIMCO, which has $475 billion in assets under management. Gross' Total ReturnBond Fund (FUND: PTTAX  ) has beaten the S&P over the past five years. What's he say about 2006? Here's what he told MarketWatch columnist Paul B. Farrell two weeks ago:

Now after 300 basis points and 17 months of tightening -- which, by the way, is typical of prior bear cycles as well -- it should only be logical to expect a slower economy in 2006.

Translation: Rising interest rates tend to precede bear markets. (It's worth noting, however, that Gross appears to be making a big bet on interest rates continuing to creep ever higher. See here for more.)

Pick better stocks
This isn't to suggest that you should simply cash out your stocks and run for the nearest mattress. Far from it. But it does mean you'll have to be more disciplined as a stock picker. You'll have to look closely at competitive advantages, valuations, products, and management. And then choose the very best of the best.

Or you can get help. Our Stocks 2006 annual review (which you can get free with a subscription to Motley Fool Stock Advisor) includes 12 of our best picks for the year ahead, including David Gardner, Philip Durell, Bill Mann, and both of your Foolish duelists. It could be the cheapest portfolio insurance you'll get in a market that's ready to claw away at your returns.

Wait! You're not done. This is just a quarter of the Duel! Don't miss the Bull opening argument and the Bull and Bear rebuttals. Even when you're done, you're still not done. You canvoteand let us know who you think won this Duel.

Fool contributorTim Beyers, like Stephen Colbert, places bears near the top of the threat list. Bears: You're on notice. Tim didn't own shares of any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Foolprofile. The Motley Fool has an ironcladdisclosure policy.


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