What Could Go Wrong In 2006?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
January 17, 2006

IN THIS ISSUE:

1. Wall Street Journal Survey Of Leading Economists

2. What If Energy Prices & Inflation Soar This Year?

3. What If Home Prices Are Headed For A Bust?

4. Are U.S. Consumers Finally Tapped-Out?

5. Terrorism & Unrest In The Middle East

6. Stocks & Bonds – Another Lackluster Year?

7. How To Invest In This Choppy Equity Market

Introduction

In my January 3 E-Letter, I summarized for you the latest forecasts from the highly respected Bank Credit Analyst for 2006 and beyond. As you will recall, those forecasts were, on balance, quite optimistic, with BCA expecting another year of solid economic growth. This week, I will also share with you the conclusions from the Wall Street Journal’s latest survey of 56 leading economists for 2006, which is also quite positive.

In that same January 3 E-Letter, I also discussed the “yield curve,” given all the hype we are hearing about it of late. If you recall, it was my view that: 1) the yield curve is not likely to invert significantly; and 2) a flat to slightly inverted yield curve is not likely to slow down this economy much, nor will it lead to a recession this year. BCA agrees.

While the consensus views of highly respected sources such as BCA and the economists surveyed by the Wall Street Journal remain quite positive for 2006, there are of course many who hold different, more cautious and even negative views for the New Year. And I’m not just talking about the “gloom-and-doom” crowd that is always negative, and for whom the sky is always falling.

While I continue to believe that the most likely scenario for 2006 is one in which the economy has another relatively good year, one in which inflation stays relatively low, and one in which consumers continue to spend, perhaps it’s not a bad idea for us to focus this week on what could go wrong in 2006. It’s never a bad idea to consider the “What if’s…” occasionally.

So, we’ll start with the latest results of the Wall Street Journal Survey of 56 leading economists, and see how their forecasts compare to those of The Bank Credit Analyst. Then we’ll delve into what could go wrong in 2006 – and there are many things that could potentially go wrong (as there always are). We will finish up with some conclusions and my thoughts on what you should be doing this year to both protect your assets and hopefully make some money this year.

Wall Street Journal Surveys Leading Economists

On January 3, the WSJ published the results of its year-end survey of 56 leading economists. Overall, the results were very positive regarding the outlook for 2006, clearly suggesting a fifth consecutive year of economic expansion.

The consensus estimate of the 56 economists surveyed is that GDP will rise 3.5% in the first half of 2006 and 3.1% in the second half. Most importantly, few of the economists surveyed believe that a recession will unfold in late 2006. While these estimates are more than respectable, they are below the average of 4.1% over the last 2½ years.

On balance, the economists are also optimistic about inflation. The CPI rose 3.5% in the 12 months ended November. For 2006, however, the economist consensus estimate was for inflation to cool to a 3.1% rate in the first half of the year and then recede to 2.3% in the second half. If correct - both on the GDP front and the inflation front - this should assure that the Fed will cease hiking interest rates soon (more on this below).

On balance, the economists believe that the current economic expansion can continue for several more years. Only 15% of those surveyed believed that a recession will occur in the next couple of years. This level of optimism assumes, of course, that there is not another huge spike in oil prices; the consensus was that oil prices would generally stay in a range of $50-$60 per barrel in 2006. That remains to be seen, of course.

As for interest rates, the consensus was that the Fed will hike two more times, thus putting the Fed Funds rate at 4.75% in March. The consensus was also that long-term rates would remain generally low. The consensus forecast suggests that 10-year Treasury Notes will remain below 5% for all of 2006. This suggests a continued trading range in bonds.

The consensus was that stocks will be higher in 2006. A plurality of the 56 leading economists surveyed expects the Dow to end 2006 somewhere between 11,000 and 12,000. Very few expected the equity markets to be down for 2006.

Perhaps the area with the most consensus was the housing market. Most of the economists surveyed agreed that the US housing market will cool off in 2006 (in fact, it has already), and on balance, the economists believe this will slow economic growth slightly in the New Year. But more importantly, few of the 56 leading economists surveyed expect a bust in housing this year. Most expect housing prices to stagnate or move only slightly lower this year, although some of the previously hottest markets could show more weakness than others.

Importantly, there was a broad consensus among the 56 economists that US businesses will significantly increase capital spending and new investment in plants, equipment and technology in 2006. This trend was already well underway in the last half of 2005, and the economists believe this surge in capital spending will offset much of the economic drag from the slowing housing market.

In general, the consensus forecasts of the 56 leading economists surveyed by the WSJ were quite similar to those put forth by The Bank Credit Analyst (as summarized in my January 3 E-Letter.) The cornerstone to these optimistic forecasts is that inflation will remain relatively low and as a result, the Fed will not go overboard in raising interest rates and risking a sharply inverted yield curve and a possible recession later this year.

In my view, this is the most likely scenario. As I have stressed for many years, the US economy has continued to surprise on the upside. But as we all know, even the best economic forecasts are vulnerable to surprises. BCA, for example, readily admits that if it’s forecast for continued benign inflation is wrong, then most of their other forecasts will probably be wrong also. So, let’s take a look at some of the things that could go wrong in 2006.

Energy Prices & Inflation Could Soar

Perhaps the most surprising thing about 2005 was the fact that we saw oil prices skyrocket to $70 per barrel at one point, with gas prices briefly above $3.00 per gallon in many parts of the US, yet the economy seemed virtually unfazed. GDP growth was robust in the 3Q with an annual rate of 4.1%. Most analysts expect the 4Q GDP number to be almost as strong.

As noted above, the Consumer Price Index rose by 3.5% for the 12 months ended November (latest data available). However, the “core rate” of inflation (minus food and energy) rose only 2.1% over the same 12 months. As noted above, most leading economists expect the CPI to ease to around 3% in the first half of this year, and then recede even further in the second half of the year. This is consistent with BCA’s forecast.

Yet we all know that these benign inflation forecasts will be wrong if we see another explosion in energy prices. As this is written, oil prices have climbed back to the $65 area, after having bottomed out around $57 in late November. Obviously, if oil prices are headed for new highs above $70 per barrel, this will not be good for the economy or inflation. No question that if oil prices are headed for $100 a barrel, these optimistic forecasts will likely be wrong.

While core inflation remained tame despite the big run-up in energy prices in 2005, if oil prices are headed for $75-$100 per barrel, that will result in a big jump in inflation – including the core rate – which will begin to rise briskly if energy soars to these levels. Just think about anything you consume that includes plastic, or any other oil-based components, and you can see how the core rate of inflation could rise significantly.

My view, and that of most energy analysts I read, is that oil prices are not likely headed for new highs, and the most likely scenario is for oil to remain in a trading range of $50-$65 per barrel this year. But that assumes no big surprises and no major supply disruptions. As noted above, oil prices are now back at $65 per barrel as this is written.

Will The Fed Go Too Far In Raising Rates?

This question is on the minds of economic and market analysts the world over. The consensus view is that the Fed will raise rates by a quarter-point at the end of January and one more quarter-point near the end of March, thus putting the Fed Funds rate up to 4.75%. The general feeling is that new Fed chairman Ben Bernanke will decide in late March to take a break from raising rates, particularly if the economic and inflation data look relatively tame.

Yet the Fed has a long history of over-doing rates on both sides of the equation. In the late 1970s, the Fed spurred the economy by monetizing massive amounts of government debt, and we saw runaway inflation. In the early 1980s, Volcker ratcheted rates up to 14-16% and squashed inflation, but it also threw the economy into a recession.

There are those who (perhaps rightly so) believe that Alan Greenspan spent the better part of the 1980s fighting inflation that didn’t really exist, and that this ultimately led to the stock market crash of 1987 and later on, the recession of 1990-91. In the late 1990s, the Fed raised rates again, and this in part led to the recession of 2001-02.

Many believe the Fed has learned from its mistakes in the past and will not repeat them in the years ahead. Generally, I would agree with that view, but we will find out soon enough. It remains to be seen if the Fed goes too far in the current rate-hiking cycle. In any event, I have no doubt the Fed will raise rates significantly more than is currently expected if inflation rises more than is currently projected. While this is certainly not the most likely scenario, we have to keep it in mind as a potential negative surprise nonetheless.

Also keep in mind what I have pointed out several times in recent months: these quarter-point rate hikes are primarily the Fed’s way of “reloading” policy options for whenever the next recession rolls around.

Is The Housing Bubble Going To Burst?

This, of course, is another critical question on the minds of analysts everywhere. I believe it is safe to say that there is a broad consensus that the US housing market, and real estate in general, have hit a peak, at the very least, and prices are slowly cooling off across most of the country. Hopefully, you took my advice late last year to take some profits and lighten-up in speculative real estate and real estate mutual funds.

We have now seen more than anecdotal evidence that a top has occurred in housing prices. More houses are on the market; the average time to sell a house has increased; soaring home prices have frozen many first-time buyers out of the market; and mortgage applications have plunged over the last couple of months. Home prices are clearly softening in many parts of the country.

So, the question is whether the home market simply goes soft (stagnates) for a while, with prices declining modestly in some of the formerly hottest markets, or are we in for a serious downturn in home prices? As I discussed in my January 3 E-Letter, BCA believes it will be the former, that home prices will stagnate for most of 2006, with some modest declines in the hottest markets. They do not believe we are in for a bust . Ditto for most mainstream economists who believe we will not see a bust.

There are plenty of others, however, who believe we are headed for a bust in home prices and real estate in general. And there are plenty of arguments to support such a case. I have read numerous recent articles on the subject of a housing bust. Perhaps one of the most compelling was written recently by Gary Shilling (economist, columnist and investment advisor). Shilling is convinced that we are headed for a serious housing bust. [ CAUTION: If you choose to read his latest column on housing, be prepared to get unnecessarily depressed!]

As usual, I choose to favor BCA’s latest outlook on the housing market, which cites a great deal of historical and other data suggesting a period of stagnation and adjustment, but not a bust, in the US housing market just ahead. Many other mainstream economists also subscribe to this less apocalyptic view. But when talking about what could go wrong in 2006, the possibility of a housing bust must certainly be high on our list.

Are U.S. Consumers Tapped-Out?

Year after year for over two decades, I have read one economic/financial/investment writer after another predict that US consumers were tapped out, that they were too heavily in debt, and that this would lead to a serious recession – always just around the corner. Yet year after year after year, consumers have surprised on the upside in terms of spending, and the economy has done likewise. Despite widespread predictions of a significant slowdown in consumer spending, we saw a much stronger than expected holiday shopping season.

Since consumer spending accounts for over two-thirds of GDP, then the overall financial health of US consumers must be included whenever considering what might go wrong in the near future. In this regard, we all know that consumers have continually increased household debt for the last 20 years or longer, through good times and bad, to the point that the national savings rate has actually fallen into negative territory for the last five months in a row.

People often ask me how this can be, how can people continue to spend more than they make? Obviously, one popular way is to load up the credit cards, which seem in endless supply for just about anyone with a postal address. But more critically, millions of consumers have sucked all or most of the equity out of their homes by way of mortgage refinancing.

Clearly, the deterioration of consumers’ financial health over many years, including the borrowing and spending of their home equity in many, many cases, is NOT a positive development for the future. As I have noted many times, a day of financial reckoning IS in our future . But again, the question is when? Keep in mind, we are talking about 2006 here.

As I discussed in my January 3 E-Letter, BCA made it clear they do not believe that 2006 holds the “day of reckoning” scenario, barring some unexpected, major surprises. Regarding the status of US consumers, and consumer spending, for this year, BCA wrote:

The U.S. consumer is a very resilient creature, with real spending growth averaging 3¾% so far this year [2005]. Clearly, the strong housing market has provided significant support [to consumer spending] via home equity withdrawal. This shows up in the fact that the personal savings rate has been in negative territory for five months in a row for the first time since the Great Depression. The case for a consumer retrenchment is now very compelling.

…It is hard to see how a consumer slowdown can be avoided given the above trends. However, we expect a moderation in [consumer spending] growth rather than a collapse, given that housing should cool gradually and employment and real incomes should continue to grow. [Emphasis added, GH.]

Let me make sure you follow BCA’s outlook here. As discussed in my January 3 E-Letter, BCA expects GDP growth of 2½-3% or better in 2006. They expect stagnation, rather than a bust, in the housing market this year. And finally, they expect consumer spending to continue to increase in 2006, but at a slower rate of growth. They do not expect consumers to fall off a cliff.

Clearly, we hope that BCA is correct in these forecasts. However, when considering what could go wrong in 2006, home prices are a major key. If home prices stagnate, with only some modest declines in the hottest markets, then I agree that most consumers can live with that. However, if home prices start to decline in a more significant way, then the wheels could come off this economy fairly quickly, in my opinion. We’ll just have to wait and watch closely.

Terrorism & Unrest In The Middle East

Obviously, the threat of another major terrorist attack on American soil is always a spoiler for any economic forecast. While we have not experienced another major attack since 9/11, we cannot rule this out as another surprise that could cause things to go wrong this year. Actually, a major terrorist attack in just about any large Western country could have a serious impact on consumer confidence, both here in the US and abroad.

As this is written, it is entirely unclear what will happen in the Middle East in the coming months. Almost without question, leadership in Israel will soon change. While it remains to be seen, it will not be a surprise if Israel falls back into the hands of the hardliners, in which case the transfer of territories to the Palestinians could blow up again. If so, this could be a major distraction for not only the Middle East, but also for Europe and America.

Iran has restarted its nuclear program, and its current leader has vowed to attack Israel. As this is written, world leaders are discussing how to stop Iran’s development of nuclear weapons. I think it is safe to say that the Middle East will continue to be a tinderbox that could result in numerous surprises – none of them good.

Don’t Automatically Assume The Negatives

While it is always a good idea to go through such an exercise of identifying the potential negatives and surprises (not that we’ve covered them all, by any means), it is not a good idea to assume that these are the most likely scenarios. In fact, I would argue just the opposite. After all, the economy and consumer spending have continually surprised on the upside for over two decades. Inflation has been on a steady decline throughout the same period. Financial assets (stocks and bonds) have enjoyed one of the strongest bull markets in history since the recession of 1981-82.

While it is always a good idea to keep the potential negatives on our radar screens, it is not usually the best idea to invest accordingly. During the 1980s, inflation was the wolf behind the door and many investors stayed on the sidelines for fear of losses. Now we know that those who went to cash back then missed out on the start of one of the greatest stock bull markets in history.

In 1999, the Y2K problem was predicted to tank the economy and stock markets. Many investors moved to the sidelines, only to miss out on a 20%+ return in the S&P 500. Later on, investors saw the bear market of 2000–2002 and the terrorist attacks on 9/11 as reasons to go to cash, only to miss out on very impressive stock market gains in 2003.

The bottom line is that there are always going to be uncertainties on the world stage with the potential to affect your investments. If you stay on the sidelines every time a potential crisis looms, you’ll never be invested and will do well to earn enough on your savings to keep up with inflation. Investing during times of uncertainty requires that you invest wisely, and not just throw your money into the market and hope for the best. I’ll discuss more about this later on.

Stocks & Bonds – Another Lackluster Year?

Of the 56 economists surveyed by the WSJ, 33 (59%) predicted that the Dow Jones will end 2006 somewhere between 11,000 and 12,000. That view generally reflects most other forecasts I have seen from other mainstream analysts. As noted in my January 3 E-Letter, BCA expects stocks (as measured by the broad indices) to be sideways to slightly higher in 2006.

As discussed above, and in recent E-Letters, most analysts including BCA expect bonds to remain in a fairly limited trading range in 2006 as well. For that reason, let’s focus on stocks and equity mutual funds for this discussion.

If you are an “index” investor, or if you follow most any “ buy-and-hold” strategy, then you got a real taste of what it’s like to be in a trading range market last year. The Dow Jones was down fractionally in 2005, and the S&P 500 Index was up only marginally last year. Gone are the days when analysts routinely predicted annual equity gains of 15-20% or higher, as was commonplace in the late 1990s.

Yet, the journey to these lackluster 2005 returns was anything but calm. There was a significant amount of volatility during the year caused by disasters, the skyrocketing price of oil and uncertainty about how far the Fed would go in raising interest rates. With this greater volatility came greater risk, but the eventual reward certainly did not justify this increased risk.

One of the main equity themes I have tried to emphasize over the last couple of years – as return expectations have come down – is that while upside expectations have come down, the risks in the markets remain as high as ever. You can bet that if any of the potential negative surprises discussed above come to pass, the equity markets could get hammered.

This is why I continue to recommend “active management” strategies that have the ability to move to the sidelines and sit in the safety of money market funds, or that can “hedge” their positions, should negative surprises come to pass.

Earlier, I mentioned that you have to invest wisely during times of uncertainty, rather than just hanging on to the roller coaster. Utilizing active management strategies to produce “absolute returns” can be a smart way to invest during uncertain times. The ProFutures AdvisorLink® program is built upon the investment philosophy of minimizing risk through active management. In fact, we call AdvisorLink® “The Smart Way To Own Mutual Funds.”

All of the professional Investment Advisors and programs that we recommend in AdvisorLink® utilize active management strategies to one degree or another. During uncertain times, a professional money manager is there to decide when to exit the market, hedge positions or transition to other market sectors. They are also there to decide when to get back into the market, which is, by far, more challenging than deciding when to exit the market.

The point is, many of these professionally managed investment programs actually have the potential to benefit from the market’s increased volatility. If you would like the chance to profit from market volatility rather than be a victim of it, you need to check out our AdvisorLink® program.

Based on our preliminary December estimates, all of the AdvisorLink® equity programs were positive in 2005, despite the very difficult market conditions, and all but one provided absolute returns in excess of the S&P 500 Index return. Of course, past results are not necessarily indicative of future performance. We do not post estimated performance numbers on our Top Performers web page, but we will update our Advisor performance information as soon as we have final year-end numbers from our recommended Advisors, which should be within the next couple of weeks.

I can tell you that our preliminary estimates show that all of our AdvisorLink® equity programs had gains in December. So, while the November 30th performance numbers (net of all fees and expenses) are impressive, the final year-end numbers should be even better. Of course, the final performance numbers can vary from our preliminary estimates, and past results are not necessarily indicative of future results. When visiting our website, also be sure to read the important disclosures for the performance information presented for each program.

With 2006 looking to be another low return/high volatility year in the markets, it remains my belief that most investors would be well-served to have a portion of their equity portfolios invested with professional managers with active management strategies. If you are on the sidelines, or are tired of the buy-and-hold roller-coaster ride, then you need to check out our AdvisorLink® programs. You can either click on this link to take you to our Top Performers web page, call one of our Investor Representatives at 800-348-3601, or e-mail us at mail@profutures.com. This time next year, I think you’ll be glad you did.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Thomas Sowell: Senate “Condemnation” Hearings
http://www.realclearpolitics.com/Commentary/com-1_17_06_TS.html

Republicans long for a new Reagan.
http://www.opinionjournal.com/columnists/bminiter/?id=110007824

A Seasonal Shot of Necessary Gloom
http://nationaljournal.com/crook.htm