NEW YORK (MONEY Magazine) -
Here's how I see the outlook for stocks shaping up in 2006: Large swaths of the market are now undervalued, and many giant growth stocks are out-and-out bargains. If the economy performs as expected and the geopolitical environment improves a bit, the market could take off.
Of course, I could have said the same thing a year ago, and in fact that's exactly what I did write in last year's forecast story. Yet the market is down slightly since then.
What gives? The geopolitics aren't great yet, but they're no worse than they were last year. And the economic numbers -- unemployment, GDP growth -- are mostly terrific.
Earnings per share are running 14 percent ahead of last year, and since stock prices haven't risen overall, price/earnings ratios are getting lower.
Even so, some forecasters worry that a recession may be on the way; others just think above-average growth in corporate profits may not continue.
"Profit margins right now are just about as good as they can get," says Andy Engel, senior research analyst at the Leuthold Group, an investment analysis firm in Minneapolis. That doesn't automatically mean that stocks are a bad buy, he says, but "you'll probably get better buying opportunities sometime in the next five years."
I'm not convinced that a recession is coming.
Yes, consumer spending could weaken if housing prices soften, or the Federal Reserve could raise interest rates too fast and tip the economy into recession.
But it's just as likely that business will keep on chugging along. Much of the reason for the recent poor performance of growth stocks, I believe, is the result not of the business cycle but of another cycle -- the alternating periods of strength and weakness for growth stocks vs. the rest of the market.
This phenomenon is quite noticeable if you compare shares of large growth companies that trade at high price/earnings ratios with value stocks, shares of companies in businesses like banking and consumer products, that trade at lower P/Es.
Growth stocks have underperformed value shares since 2000, and today they look about 12 percent cheaper. But it's rare for one of these trends to last more than six or seven years.
Leuthold's Engel may be right about there being a cheaper entry point later -- but better to be early than late.
What about the long run?
There is, however, a question about how the market will perform longer term.
More forecasters believe that returns will be lower over the next couple of decades than they've been in the past.
Why? Returns come from three components: earnings growth, dividends and the expansion or contraction of P/E ratios. And the latter two appear likely to contribute less to stock returns than they did over the past 80 years.
"In the 1920s," explains Peng Chen, chief investment officer at Ibbotson Associates in Chicago, "the average P/E was just over 10. Now it's close to 20. Over 80 years, that doubling has added almost one percentage point a year to stock returns."
But that increase occurred as stock ownership went from being a privilege of the very rich to a popular way of saving for the mass of affluent Americans. Now that this transition is complete, "it's hard to see how P/Es can rise a similar amount again," says Chen.
As for dividends, at today's reduced levels, they don't add the oomph they used to. "Up until the last 20 years, yields on blue chips were often 4 percent or more," says James Stack, editor of the InvesTech Research newsletter. "But today the yield is less than 2 percent."
Stack projects that earnings will grow an average of 7 percent a year over the next couple of decades. Still, a 9-percent annual return -- 7-percent earnings growth plus a 2-percent yield -- clobbers most of the alternatives.
Yields on 10-year Treasuries are now around 4.5 percent. And sectors such as energy and real estate look overinflated and vulnerable to setbacks.
What to look for
It's possible to do better than that 9-percent hurdle without taking extra risk, I think, if you favor companies that dominate their industries and have strong finances.
The best deals are likely to be stocks that aren't overly expensive. Look for shares trading at less than 20 times projected 2006 earnings. Sort through the thousands of stocks that trade publicly, and you'll find that fewer than 200 meet all these criteria.
I maintain a list of 70 blue-chip growth stocks that look promising -- see the Sivy 70 here. Some of the companies on the list are well-known names that are widely recommended but have fallen in price since January.
Citigroup (Research), for instance, trades at 11 times projected earnings for 2006. And although lots of big banks are cheap, Citigroup is attracting interest now because it might be broken up.
General Electric (Research) remains a superb opportunity with a 2.5 percent dividend yield, unusually high for that company.
Home Depot (Research), the premier retailer for do-it-yourselfers, seems like a bargain at current prices.
Cisco (Research), the leader in networking systems, is also priced attractively.
Nike (Research) has a franchise that has made a great comeback -- not to mention that cool swoosh.
You'll also see a few less-recognized stocks on the list that look timely.
Fortune Brands (Research), a collection of top consumer brand names from Jim Beam bourbon to Titleist golf balls to Moen faucets, trades at a 15 P/E.
And Illinois Tool Works (Research), a midwestern producer of specialty fasteners, coatings, laminates and adhesives, is just the sort of stock that ought to be rising in a healthy economy. Instead, the shares have drifted lower all year and now trade at a P/E below 15.
That's a deal you can't ignore.
Moves for 2006...