As goes January
Last year's bellwethers suggested stocks would be weak, but this year the outlook is much brighter.
NEW YORK (MONEY Magazine) - As goes January, so goes the year, according to an old Wall Street saying. In fact, forecasters watch market action during the first few days of January to get a sense of investors' expectations for the rest of the year.
That bellwether proved to be fairly accurate in 2005. On the first day of trading, both the Dow and the S&P 500 declined, and the indexes continued to erode over the first week. In line with that indicator, the Dow ended 2005 slightly down, while the S&P 500 barely finished up.
Skeptics dismiss the January bellwether as little more than superstition. But I think it does have some real predictive value. Investors take tax losses, simplify their holdings and otherwise try to clean up their portfolios going into the year-end holidays. Then they come back after New Year's ready to take a fresh look at economic prospects for the coming year.
The January bellwether may not tell you anything about the actual economic data. But it does give you some genuine insight into how investors feel.
With that in mind, the week just ended shows very positive sentiment for stocks at a time when much of the commentary is negative. On the first trading day of 2006, the Dow shot up 130 points, and the index closed the week up more than 240 points.
Given such positive market action, it's important to review the pessimists' key arguments and see why they may be wrong.
The first worry is that the economic expansion has gone on for a long time and that the stock market's recent sluggishness is a sign that the economy is running out of steam.
By historical standards, however, expansions can go on longer than this one has. And more important, stock prices are still undervalued by 10 percent -- and growth stocks by as much as 20 percent -- compared with their gains following past recessions. Moreover, in this cycle corporate profits have risen far more than in the average expansion.
The second discouraging sign the pessimists point to is the yield curve. Historically, once short-term interest rates rise more than half a percentage point above long-term rates, recessions usually follow within a year or so.
For now, two-year issues offer the same 4.38 percent yield that 10-year bonds do, so the yield curve is essentially flat.
That would normally indicate that the economy is about to slow. And in fact, even optimistic forecasters expect growth to moderate from the current 4.1 percent rate to less than 3 percent a year.
It's crucial, however, to remember that a flat yield curve is actually a sign that bond investors expect inflation to decline, and that can happen for several reasons. Many forecasters believe that the recent run-up in oil prices has overstated inflation, and that the numbers will ease over the next 12 to 18 months.
Moderate growth and slow inflation is the best of all worlds for big-cap stocks, and particularly for growth issues. If price/earnings ratios remain where they are, corporate profit growth alone should push up the S&P 500 by at least 6 percent in 2006.
If slowing inflation allows for some rise in P/Es, then a gain for the broad stock market of slightly more than 10 percent seems quite reasonable. And even bigger gains could be in store for depressed growth stocks. For likely candidates, take at look at stocks on the Sivy 70 list that are trading at P/Es below 20, or look at last week's column, where I mentioned some of my personal picks among blue-chip growth issues.
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