As I outlined in my newsletter of November, the US equity market seemed to be tracking the overall mood of the US economy. I say "mood" because in 2005 the economy was fundamentally very sound as evidenced by the higher than average gain in US GDP growth of about 3.8%. Corporate profits were large (showing double digit growth); real estate values (and thus personal balance sheets) rose again in 2005; both incomes and jobs grew as well. In contrast, the overall US stock market rose too but not significantly (S&P was up 3% and if you include dividends: about 5% in 2005). In 2005 the stock market performance was tamed by the investor's mood, and did not reflect the very strong fundamentals. Last year's mood could provide opportunities this year, but some pesky headwinds will remain to make it interesting.

The modest advance in US equities last year during a period of strong economic activity translates to more attractive valuations at current prices. In other words, if companies are more valuable today as the result of growing their earnings and balance sheets significantly in the past few years but stock prices have only moved modestly higher, there is inherently more value there. The most common expression of this is Price to Earnings ratios (PE). As we begin 2006 the PE ratio of the S&P 500 has declined from the peak at the mid 40's in 2001 to about 18 today. Project out to the end of 2006: if companies hit their earnings targets and prices do not move we are looking at a PE ratio of 15 for the S&P 500. This would be in line with historical averages. I would argue that this market deserves an above average historic valuation when you factor in low relative interest rates, high productivity numbers and strong balance sheets. That means stock prices should rise in 2006.

Another way in which valuations have improved over the last few years is that companies have accumulated significant sums of cash that are now being deployed in ways that should enhance shareholder value. Companies have been and are currently doing two things in particular: buying back company stock and paying higher dividends to shareholders. As a result of these recent valuation trends, 2006 looks potentially promising. I hedge by saying potentially because the same headwinds that dampened investors' moods last year will remain and there are a few more brewing. These include earnings growth slowing, a new accounting requirement to expense stock options, and the continued but increasing uncertainty of the Fed's next move. Add to those the federal budget and trade deficits and you have the makings of a bearish view on stocks. All of these negative trends bear watching, but actually the biggest concern that I see on the horizon is the puncturing of the real estate bubble and the possibility that consumers might weaken later in the year under the strain of higher costs and weaker real estate values. While I respect these bearish views, I remain cautiously optimistic that while we will likely have a slightly more volatile year in stock prices as a result of these concerns, in the end valuations matter and I expect an up year in 2006.

My optimism is based on many factors but they begin with current valuations. As outlined above, for the first time in a long while, equity prices are at least reasonable if not cheap. In addition to current valuations other trends appear positive. We expect that, while likely slowing from the 14% that is expected for the 4th quarter of 2005, earnings growth will remain solid in the 8 % range for full year 2006. This year we should also see an end to the Fed's interest rate hikes; strong corporate balance sheets will continue to allow companies to add value to shareholders; inflation should be contained. There are signs of a potentially significant increase in business demand for goods and services and the effects of lower capital gains tax rates and dividend income rates through 2008 (and maybe 2010) will continue to emphasize and reward equity investing. We expect to see the economy continuing its expansionary GDP rates of around 3% for the year. Finally, I believe that for the first time in a while investors will recognize the relative appeal of stocks as compared to other asset classes. The bond market looks weak with rates rising and the real estate market appears destined to decline. As baby boomers realize that in order to retire they need to grow their nest eggs more, they will be more willing to take the plunge back into stocks. In my view investors throughout the year will gravitate toward believing that stocks deserve a preferred status in their portfolio once again.