Outlook 2006

Will incoming Federal Reserve Chairman Ben Bernanke continue to hike short-term interest rates? Will the price of oil and natural gas head even higher? Will more storms bash the Gulf Coast? Will Israel bomb Iran? Many events could buffet financial markets in 2006--and all are questions investors would love to see answered before putting their money to work.

As any Wall Street sharpie will tell you, investors can own stock in companies making fat profits, but a terrible market environment can still lead to lackluster returns. That was pretty much the story of 2005, when the companies constituting the Standard & Poor's 500 index saw their earnings grow an estimated 13 percent, but the index gained only 4.9 percent, with dividends reinvested. (The Dow Jones industrials were up 1.7 percent for the year.)

Blame a series of Fed interest-rate hikes, a 40 percent jump in oil prices, and $58 billion in losses from three devastating hurricanes for the paltry performance. Market strategists call these "exogenous events," which play havoc with even the keenest forecasts. Citigroup chief U.S. equity strategist Tobias Levkovich says that "investors can make some pretty good gains in 2006." One of his valuation models, taking into account low long-term interest rates and continued strong earnings, suggests the S&P could rise 20 percent next year to as high as 1500. That's not far from the S&P's all-time high of 1527, reached in March 2000.

Cautious. But sorry, all you superbulls, Levkovich isn't going quite that far. Instead, his self-described "conservative" year-end target for the S&P is 1400, a 12 percent gain. His two big worries: high energy prices and the threat of protectionist legislation from Congress designed to shield American workers from outsourcing.

When market gurus aren't trying to calculate the impact of various scenarios on their carefully crafted forecasts, they're looking to the past for clues to what's ahead. There's an old market axiom called "three steps and a stumble." Whenever the Fed raises the discount rate (what commercial banks pay to borrow) three times, the market then takes a tumble. Well, in 2005 there were eight steps--plus eight increases in the rate on overnight loans between banks--and while the market didn't soar, it didn't really stumble either. Indeed, since the Fed began tightening in mid-2004, the S&P 500 has risen by about 12 percent.

One reason stocks have held up so well is that the economy remains strong, growing at 4.1 percent in the third quarter. James Paulsen, chief investment strategist at Wells Capital Management, says old precedents don't apply to this tightening cycle, since it began from the lowest interest rates in almost half a century. All the Fed has done so far, Paulsen explains, "is reverse an abnormally loose monetary policy undertaken to avoid a severe deflationary downturn after the collapse of the Internet stock bubble." Without the Fed's "depression panic," short-term rates probably would have bottomed fairly close to where they are today. Essentially, the Fed has just now brought interest rates back to typical post-recession lows. "So I think the Fed will keep tightening, the economy will stay strong and take stock prices higher," he says.