Outlook 2006

If you don't buy the theory that the market will shake off more Fed increases, then you are probably not so bullish on stocks. Michael Darda, chief economist and director of research for MKM Partners, thinks there will be plenty of rate hikes and thus slower corporate earnings growth. He sees the S&P climbing to 1375 or so from its year-end 1248. "I'm more worried about inflation than most, and I think the Fed will go a lot further than many people expect," he says. "But if things turn out better, [the market] could move quite a bit more than that." Darda believes the huge surge in the price of gold last year--flirting with 25-year highs--presages a significant rise in inflation. He expects the core consumer price index (excluding volatile food and energy costs) to rise above 3 percent in 2006--it rose 2.1 percent during the past year--as the Fed moves the fed funds rate to over 5 percent.

What many analysts do agree on is that the market doesn't seem to have much downside risk. Because profits have risen faster than stock prices, the market's valuation on a price-earnings basis has gotten cheaper. Right now, the S&P 500 is trading about 14.5 to 15 times next year's expected earnings--right around its historical average. Citigroup research has found that this P/E level has been followed by higher stock prices 69 percent of the time over the past 71 years, with an average return of 12.5 percent.

If Paulsen is right and U.S. and global growth is more robust than most economists expect, it'll be good news for small stocks and technology issues. Darda thinks 2006 might resemble the period from early 1988 through mid-1989, which was marked by increasing inflation, rising rates, and substantial Fed tightening. But stocks did pretty well, with the S&P 500 gaining 23 percent as it rebounded from the 1987 crash. The best sectors during that period were telecommunications, insurance, and transportation. So market history and valuation models agree that 2006 should be a good year for stocks. And what about all those potential "exogenous" factors? They should make you cautious, not bearish, says Levkovich: "There are no more problems out there than there were 10 or 20 years ago."