What to look for in 2006

While we are sceptical of those making macroeconomic predictions, we are also warry of those unwilling to make bold enough predictions to help others actually make money.

So after much deliberation, we are going to lay out our expectations of how 2006 may unfold.

We think the big story of 2006 will be the price of Oil. We think Oil is going back through $70 a share and beyond. We think this price increase is being driven mostly on the demand side, as non-OECD countries grow their economies and increase their Oil consumption. Investments that have been made to increase supply will not prove sufficient to keep up with this demand. Already, we have seen a rising U.S. dollar towards the end of 2005, a possibily slowing U.S. economy, moderate winter weather, and yet the price of Oil has bounced off $55 strongly and now resides around $63 a barrel. We are not able to predict how high Oil will go, but we think whatever the final price, it will be a surprise for most people.

The other big story of 2006 will be interest rates. We think the Fed will be facing an unenviable dilemma: namely Oil and other inflation in conjunction with slowing economic growth. We expect the Fed to stop raising rates at 4.5% - 5.0%, with the likely final number being an awkward 4.75%. We think this rise in rates will severely hurt the housing market, which will flow through to the rest of the economy. We look for bad economic numbers (employment, GDP growth) beginning around March. To date, we have been impressed by how well the economy has performed, so we do think there is an outside possibility that the economic could continue to surprise. But given the fact that all the economic drivers of the past several years (housing, government spending, lower interest rates) are topping out, we believe an economic slowdown to be more likely. Despite the economic slowdown in the U.S., other economies may continue to advance. Japan's stock market performance, and China's, India's and Russia's booms may all continue, thereby driving the inflation of internationally-priced commodities. How the Fed reacts will be fascinating to watch. Our belief is they will be more inclined to lower rates, even as Oil advances, in order to keep the U.S. economy growing. If the scenario we forecast does emerge, we look for lots of confusion and volatility in the marketplace, as market participants attempt to disgest the meaning of this new paradigm.

So where should investors place their money in 2006?

• Have some Oil stocks. We like XOM Leap Options (string 70 2008s are our favorite at $4.2) as a good hedge against our forecasted Oil inflation. We also like PTF, a Oil trust that yields over 10% and pays dividends monthly.
• Short-term, high-yielding preferred stocks and corporate bonds. We think there are still a few gems out there that provide greater yield and less risk than most other debt instruments. Among these are GAJ and Amerco Series A. Both provide yields well above 8% will what we perceive to be little default risk.
• Some hedge against the U.S. dollar. While the U.S. dollar has performed very well in 2005 - a result mainly of interest rate differentials - we think the long-term fundamentals signal U.S. dollar weakness. We continue to believe that a conservative and well-managed portfolio should have some protection against the U.S. dollar. We think that FAX and FCO are good ways for the average investor to achieve such protection.

What to avoid?

• Financial services stocks. We think financial services stocks will perform badly throughout 2006. A flat yield curve, over-extended consumers, a slowing economy and housing market will slow growth across a variety of financial services sectors, including credit cards, mortgages, bond trading, and much more. We expect net margins to stay tight and defaults to rise. Not a pretty picture.

In the end, we don't think 2006 will be a terrible year, but one where it pays for investors to be cautious. Foreign stocks will likely continue to do well, although likely not quite as well as 2005. U.S. stocks are hardest to predict, and depend greatly on how much the U.S. economy slows. If forced to wager, we'd guess U.S. stocks will return around 5%, and that better returns can be had in the areas highlighted above.