Expecting the economy and corporate profits to continue to do well next year, although at a slower pace than in 2005, Standard & Poor's of New York is predicting that the S&P 500 will return 8.5% in 2006 and that the gross domestic product will rise 3.4%.

Over the past five years, the S&P 500 has delivered a negative 1.02%, but large-cap growth stocks have delivered a negative 3.61%. The unimpressive performance of large-caps is a result of the massive progress in the bubble years of the 90s. From 1994 to 1999, the S&P 500 rose 220%, which is 3.5 times the growth of operating earnings in that period, according to S&P. Although large-cap investors have not had much reason for celebration over the past five years, S&P believes higher-quality stocks will outperform the market in the coming year.

S&P also views corporate earnings as being on the rise. The operating earnings on the S&P 500 rose from 56.13 in 2000, to about 76.80 in 2005, which is a 36.8% increase, despite the 31% decrease in operating earnings in 2001. In the coming year, S&P analysts see operating profits on the S&P 500 advancing by 11.5%, to a record 85.60.

Likewise, S&P expects dividends to increase. "Through Dec. 7, S&P logged 300 dividend increases by companies in the S&P 500 this year. As a result, we now expect dividends on the index to total 22.10 in 2005," said Joseph Lisanti, editor of Standard & Poor's The Outlook. "With the payout ration of the S&P 500 low by historical standards, we see room for additional dividend increases in 2006. For next year, we project S&P 500 dividends will total 24.50, a 10.9% advance."

S&P analysts also believe that the $200 billion that is likely to be spent in an effort to rebuild after Hurricane Katrina will definitely contribute to growth in the coming year, particularly in the first two quarters.

S&P also predicts that the Fed is likely to stop tightening the fund rate, and will leave it at 4.75%, possibly in the first quarter of 2006. There is a danger, S&P added, that if the Fed continues tightening short-term rates, the economy could slide into a recession.

Oil is expected to average about $56 a barrel, providing some price stability. However, there are many things that could contribute to a higher oil price, such as if the Gulf of Mexico is hit with another hurricane season like the one it had this year. In that case, oil prices could shoot up even further.

At the end of 2006, Standard & Poor expects that the S&P 500 will reach 1360, which is a 6.7% increase over the 1275 that is predicted for the end of this year. The projected advance is less than the average annual gain of 7.6% that the S&P 500 has posted since 1929.

Standard & Poor recommends that 45% of assets should be allocated to domestic stock, 20% in foreign equities, 20% in short-to-intermediate-term debt instruments and 15% in cash. Among sectors of the market, S&P currently favors apparel, consumer staples, healthcare, biotechnology, financials, diversified banks, data processing and outsourced services, educational services and oil and gas drilling as industries with above-average potential. Ten stocks that S&P expects to deliver strong capital gains are: Apollo Group, Automatic Data Processing, Bank of America, Coach, Franklin Resources, Genzyme, Ingersoll-Rand, Nabors Industries, Procter & Gamble and United Health Group.

The company also feels that Japan has a lot of opportunity and is finally on track for economic growth. In the first six months of 2005, the Japanese economy grew at its fastest rate in 15 years. Despite the fact imports have been up, largely due to high oil prices, Japan is still running a trade surplus, and most of its industries are more energy efficient than their global competitors.

Standard & Poors' believes that because Prime Minister Koizumi was the winner in the recent national election, Japan will soon undertake much-needed economic reforms. The expected privatization of the postal system will undoubtedly create one of the largest publicly traded banking institutions in the world. All of this makes Japan a good investment.

When considering an investment, S&P urges investors to consider their time frame for spending the principal from the portfolio, not the income. This is more important than a person's age or when they plan to retire. For investors who have a high tolerance for risk and are seeking higher overall return, increasing equity allocation is the optimal move. On the other hand, an investor who does not like risk, and may need the money in the next few years, should have a higher allocation to bonds and cash.

As for bright spots in the fixed-income arena, S&P points to municipal bonds. The average top-rated 10-year muni, as measured by the Lehman 10-year Treasury AAA muni index, yields almost 3.7%, or about 79% of the 10-year Treasury's yield.

Treasury Inflation-Protected Securities, otherwise known as TIPS, are not as attractively valued as they once were, S&P notes. However, they are still a good choice for investors who are retired, since these securities protect against inflation, which is the biggest threat for someone on a fixed income.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

http://www.mmexecutive.com http://www.sourcemedia.com

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.