Maybe I should be worried. When I sent out a request to my fellow Duelists, looking for a pair of Fools to argue on where the market was heading in 2006, I had no shortage of bearish visionaries. Bulls? Crickets chirped. Folks whistled while nervously looking away. Mr. Brightside was nowhere to be found.
Now, I don't want you to think that I assumed this position by default. Technically, that's true, but I had been upbeat about the market's chances in the year that lies ahead long before I realized that I may be the only one in the room.
Maybe I should be excited. Yes, a bull can be a contrarian. Quite frankly, it's often the best time to get itchy with the "buy" finger. See, there are plenty of reasons to get pumped about the market's direction in 2006. Allow me to count the ways.
1. The market is not historically -- or hysterically -- overvalued
When it comes to valuations, I don't need someone to spout out the ridiculous trading levels of bear-market lows circa 1933 and 1990. I realize that today's market isn't exactly cheap by those metrics. However, there is always the misconception that a market is more overvalued at the end of a good year than at the beginning. That ignores the biggest catalyst of stock-market valuations out there: improving fundamentals.
Yes, 2005 was a respectable year. Over the past 12 months, the S&P 500 has risen by 7% when you account for the dividends that were paid out along the way. However, what happens when those 500 companies -- on average -- grow their earnings, improve their book values, and hike their payouts at greater clips? That's right. The market is cheaper today than it was a year ago.
| S&P 500 | Today | A Year Ago |
|---|---|---|
| P/E | 19 | 21 |
| Yield | 1.83% | 1.71% |
| Price-to-Book | 3.06 | 3.30 |
Just a few years ago, worrywarts pointed to stratospheric multiples. It's not as though one could blame them. For a spell, the S&P 500 had a P/E in the 40s, and even dependable yet slow-footed global juggernauts like Coca-Cola (NYSE:KO) were making multiple promises that their fundamentals would never be able to keep. However, you have to go back nearly a decade to find the last time the S&P 500 was this cheap on an earnings basis. Trim your long-term horizon to a span that is just eight to nine years long, and, yes, the market is historically undervalued.
2. High interest rates aren't a death knell
Back in the 1940s, dividend yields ran as high as 6% some years. That has led some to label today's market as headed for a fall. Compound it with a dozen interest-rate hikes over the past two years, and you begin to see what some consider a frightening disparity between the T-bill rates and the pocket change one can derive from stock ownership.
I see it differently. For starters, I don't penalize the past for its lack of dynamic growth companies. It's nobody's fault that companies back then had little use for the free cash flow they generated beyond distributing it to its shareowners. These days, there are just so many other uses for retained greenery, like research and development, and cash-based acquisitions. During the 1960s, the market was limited in the sense that the Nifty 50 included some classy names such as IBM (NYSE:IBM), Coke, and General Electric (NYSE:GE) but also some ultimate laggards such as Polaroid and Xerox (NYSE:XRX). I'll take the wide-open spaces of unlimited potential in today's batch of market darlings such as Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL), or Intuitive Surgical (NASDAQ:ISRG) than that any day.
Am I concerned that money market investors who were getting 2% returns a year ago are now collecting better than 4% yields? A little. Clearly, the nearly zero-risk approach is more compelling these days than it used to be. However, who else did those interest rate hikes hit? Real estate investors and condo-flipping speculators are now facing a market where the mortgaged buck doesn't go as far as it used to. The real estate market isn't likely to crumble, but the heady gains aren't likely to continue into 2006.
Follow me here. If the gains aren't there in the housing market, where will real estate investors redirect their appreciated capital? The sums have been pretty substantial. One would think that a decent-sized chunk of that will make its way back to the equity markets.
3. Rosy about the future
You have to go back to the mid-1990s to find the last time that the S&P 500 had a P/E ratio in the teens. Naturally, this would all be landfill fodder if the prognosis weren't for corporate profits to improve in the coming year. Wouldn't you know it? They are.
Right now, the Dow Jones Industrial Average is trading at 17.4 times 2005 profitability. Analysts expect the 30 component companies to grow their net income by an average of 19% over the next four quarters. What does that mean? It means that the Dow may be trading at 17.4 times trailing earnings, but it's also fetching just 14.7 times projected profits for 2006.
Where do we go from here? I like the odds once you consider the various potential scenarios. Will the economy falter and drag corporate earnings down for the count? Perhaps, though keep in mind that the reason that we've had a wave of Fed hikes since last year is that although the economy is many things, it is not weak. The two more likely paths are that either the market dips in 2006, dropping these multiples even lower, or that it inches a bit higher yet still keeps multiples at some of the lowest levels that we have seen on this side of the millennium.
As long as corporate profits don't crater, it's a win-win situation for investors. That's why, between the eggnog sips, fruitcake nibbles, and Auld Lang Syne-ing, you owe it to yourself to start ferreting out the best stocks to own in what looks to be an upbeat 2006. One great place to start is with the new Stocks 2006 premium research publication that takes an in-depth look at a dozen stocks that are poised to thrive in what I see as an already lively market. (We'll give you a copy with a subscription to Motley Fool Stock Advisor, or you can buy it separately.) Yes, it's going to be a good year. The crickets seem to be chirping in agreement!
Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Coca-Cola is a Motley Fool Inside Value pick.
Wait! You're not done. This is just a quarter of the Duel! Don't miss the Bear opening argument and the Bull and Bear rebuttals. Even when you're done, you're still not done. You can voteand let us know who you think won this Duel.
Fool contributor Rick Munarriz relishes being the understudy for Mr. Brightside. He doesn't own shares in any of the stocks mentioned in this Duel. He is also part of the Motley Fool Rule Breakers analytical team, scouring sectors like satellite radio to find the next ultimate growth stock. You can find out more with arisk-free trial subscription. The Fool has a disclosure policy.
