Experts reveal where they believe the returns are as slower growth is predicted for 2006.

Jeffrey Gundlach was trying to enjoy his first week as chief investment officer of TCW Group Inc., his long-time employer in Los Angeles, but the crystal ball that came with his new post just didn't seem to be working right. Its vision of 2006 simply didn't warrant the type of optimistic forecast you'd expect from the CIO of a $116-billion (AUM) money-management firm, he apologized.

"We're looking at an endgame for the U.S. economic cycle," Gundlach says. "We're already past the average length of an economic expansion, and the Federal Reserve Bank began hiking short-term rates in June 2004." With a nine- to 12-month lag between Fed action and impact on the economy, the effects of the central bank's measured tightening ought to constrict growth by next year.
    Furthermore, the yield curve is currently flat (meaning there is little difference between short- and long-term interest rates), which is a late-cycle characteristic. "In fact, a flat yield curve is a pretty good indicator of an upcoming recession," Gundlach says. "The last time it was flat to inverted was 2000."

What could derail the heretofore chugging economy? A punishing double-whammy: Energy costs torpedoing household budgets, plus higher interest rates that finally quash the home equity cash-out-refinancing craze that has been so stimulative in the last few years. Weak consumer confidence readings by the Conference Board for September and October could be an omen of what's in store for next year.

"With the stock market having to fight these headwinds from the consumer economy, I sadly have to say to people, as I take the reins as CIO, that we're not terribly positive on financial assets for the next few quarters. We think it will be a tough environment to make money," Gundlach says.
    But it takes two to make a market, after all. "On the other side are people saying growth may slow but not to an extreme, because companies are well financed and they've been watching the bottom line," says economist Quincy Krosby, the chief investment strategist at The Hartford. This camp argues that as productivity levels come off their highs, corporations may ramp up spending on technology and boost the economy just as consumers are cooling their jets. Estimates of 2006 GDP from this faction of the market typically range from 2.5% to 4%.

The Market's Obsessions

How the coming year ultimately plays out appears likely to turn on the sometimes cruel relationship between inflation, the Fed and long-term interest rates, with energy prices playing the role of spoiler and Hurricane Katrina the wildcard. Consider: The Fed's job is taming inflation, which recently surged due to leaping energy costs. But the fallout from Katrina is muddying the government's statistics.

The good news for the marketplace is that the Fed is looking beyond the published data. "To determine whether the higher cost of energy is transitory," Krosby says, "the Fed is holding discussions with CEOs and CFOs across the country to get a sense of what people on the ground are seeing past the Katrina affect."

Fed rhetoric makes it clear that short-term interest rates will march north, but by how much? Most money managers expect a minimum 4.5% Fed funds rate by the time Chairman Alan Greenspan gets his gold watch, although PIMCO's fixed-income uber star, Bill Gross, sees the Fed starting to lower rates some time later next year. The fact that the Fed will have a new helmsman February 1 (former Princeton economics professor Ben Bernanke, if confirmed by the Senate) probably increases the odds of continued rate hikes.
    "Most new chairmen want to show the world their inflation-fighting credentials," says Krosby. "They can be quick to pull the trigger (raise interest rates)." And the market doesn't like huge budget deficits, she adds. "That is very inflationary and provides additional ammunition for rate increases."
    Still, if the Fed stops sooner than expected, that could be a catalyst for the markets. Remember 1994-'95? "The Fed was tightening and the market bottomed about four months before the last rate increase," says Kent Gasaway, a portfolio manager at Buffalo Funds in Mission, Kan. "The market didn't seem to believe then, just like it doesn't now [in late October], that the Fed can get it right and actually slow the economy on the margin. But that's exactly what happened, and the market doubled over the next three years," Gasaway says.
    The final piece to the puzzle is stubbornly low long-term interest rates. They reflect the bond market's expectation for inflation over the long haul. But when they're only slightly higher than their short-term counterparts, as they have been, it means bond investors aren't demanding much compensation for the risk of future inflation-presumably because they don't foresee any. That presents "a conundrum," in Greenspan's words.

"The conundrum is that the Fed sees inflation as a problem and thinks interest rates need to go higher, but the bond traders of the world have been disagreeing," says Stephen Wood, a portfolio strategist at Russell Investment Group, the investment services firm in Tacoma, Wash. "They can both be wrong, but they can't both be right," says Wood, adding that Russell forecasts "rather significant global economic deceleration heading into 2006."
    One variable that could lift long-term yields is the U.S. Treasury's plans to start issuing 30-year paper again. (Treasury yanked the long bond in November 2001, when Washington ran a surplus for one fleeting moment.) Some investors claim that long-term yields have stayed inexplicably low because of a market imbalance. Institutions have increasingly demanded long-dated maturities, but supply has been limited.
    "Reintroducing 30-year issuance will add supply to the market," although the amount of bonds planned for issue is relatively small, says Marc Seidner, director of active core strategies at Standish Mellon Asset Management in Boston. "On the margin, at least, the additional supply should take some pressure off of the long end of the yield curve and cause it to steepen."
Asset Class Prospects

Against this backdrop, what's a financial advisor to do? Begin by recognizing that cash is no longer a four-letter word. "You can actually get an okay rate of return on short-term Treasuries now-maybe 5% by early '06 if the Fed keeps raising rates," says Gundlach.
    If long rates rise, as many experts predict, asset valuations across the board will tumble. At least that's what financial theory asserts. "The starting point for pricing global financial assets is the rate on the ten-year Treasury note," says Gundlach. "When the risk-free rate goes up, risky assets have to get cheaper."
    Bonds really suffer, of course. Two sectors that have performed well in recent years, high-yield and emerging markets, may be especially vulnerable, says Morningstar Fund Analyst Gareth Lyons. The premium that investors currently earn for taking the credit risk of junk debt is near its historic low, while the bond markets in developing countries "can grow skittish quickly," he cautions, citing the potential for political upheaval and exacerbated sensitivity to rising U.S. interest rates.
    These sectors might also decline if investors begin showing disdain for riskier assets and favoring higher-quality investments, a shift that sometimes occurs in periods of actual or anticipated economic sluggishness. In the domestic equity markets, Russell Investment Group says value's multiyear winning streak over growth may end, if it hasn't already. "We saw a rotation in market leadership in the second quarter of 2005 when growth began to outperform value," Wood says.
    Looking ahead, growth is very cheap to value right now, he contends. "The relative price-to-share ratio of the Russell 1000 Value Index to Russell 1000 Growth Index is currently at one of its highest points since the inception of the indexes in 1979, 0.69. That's a strong signal growth will outperform," Wood says.

Not everyone agrees, though. "The price-to-earnings multiple of growth is currently 50% greater than that of value, and that is just about the long-term average," observes Jonathan Golub, U.S. equity strategist and a managing director of JP Morgan Funds in New York. "To us, it looks neutral on a valuation basis, or maybe favoring value."
    Whatever your view, take a closer look at funds' holdings before acting, Morningstar's Lyons suggests. "The big story is that the line between growth and value has blurred in both domestic and international portfolios," he says. "We're seeing names like Vodaphone, Nokia, Coke and Microsoft pop up in value portfolios. These are stocks many value managers avoided like the plague five or six years ago."

Favorable For Large-Cap

When it comes to market cap, large stocks are the primary beneficiary of a slower-growth economy and investor flight to quality. "At this stage in the cycle, the supply of earnings growth is starting to shrink, so paying for predictability in growth makes sense," says John Waterman, chief investment officer of Rittenhouse Asset Management, a conservative large-cap growth manager in Radnor, Pa. "We think the market will begin favoring companies that show consistent earnings growth and have strong balance sheets," Waterman says.
Whether consumers finally quit spending is a crucial issue, he adds. "Your stance on that matters a lot in where you put money within the large-cap space." Investors foreseeing consumer caution might consider conglomerate GE, with products in industrial and commercial markets that can buoy earnings regardless of what consumers do. Waterman also mentions certain types of health-care companies, including HMOs, pharmacy benefit managers, medical device companies and diversified organizations such as Johnson & Johnson.

Consumer-wary investors will probably want to avoid retail and consumer discretionary stocks, Waterman adds. Those shares were already falling by early autumn on initial fears of a consumer retrenchment. But they could rebound quickly if people's purse strings don't actually tighten, perhaps because of surprisingly gentler prices at the pump. Some investors, including Buffalo Funds, have been scouting for bargains when these sectors sell off.
    Another idea for 2006 is mid-cap. The companies are decidedly safer than small-cap names, yet have the ability to grow faster than large stocks. "Mid-caps are in the sweet spot in the market," says Buffalo's Gasaway. They're increasingly paying dividends, too, he says. "These are successful businesses that generate lots of cash, at least the ones we own."
    Sectors to watch include technology. Grant Sarris, another Buffalo Funds portfolio manager, says, "Tech stocks have underperformed for a few years but their earnings growth has been reasonably solid, cash has been building on their balance sheets, they're no longer diluting shareholders by granting too many stock options, and in some cases they're buying back stock." Proponents also argue businesses have reigned in technology expenditures for years and that has created pent-up demand.
    And energy? Even if prices remain high due to climbing global demand and limited refining capacity on the supply side, energy companies aren't known for executing optimally. "They're notorious for squandering capital," says Morningstar's Lyons. Better perhaps to invest in companies that are likely to benefit from a Big Oil spending spree.
    "As the global leader in the oil services industry, Schlumberger will be the first stop for most of the major integrated oils as they look to develop existing reserves and discover new ones," says Bill Fries, a portfolio manager and managing director at Thornburg Investment Management Co., in Santa Fe, N.M. "Schlumberger is going to have surprising demand for its services."

Opportunities Abroad

Because of the prominent role that the United States commands on the global economic stage, one's view of domestic growth necessarily colors one's outlook for the world. Fries says, "Because there is more of a global economy than ever, and because of the large consumer economy in the U.S., what happens here is pretty relevant to what goes on around the world." He's looking for 3% U.S. GDP growth in 2006 (down from the 3.6% he anticipated earlier this year) and between 7% and 9% in China. Even if the numbers are a tad lower than in recent years, that's still plenty of grease for the wheels of international commerce.
    Multinationals whose fortunes ride on global conditions could prosper in the new year, says Guang Yang, a portfolio manager and executive vice president of Templeton Global Equity Group. Yang's portfolios are 50% overweight non-U.S. compared to benchmarks and include holdings such as Denmark's Vestas Wind Systems, a wind power turbine manufacturer that has raising prices as the renewable energy movement gains momentum globally. He also touts Endesa, a Spanish utility deriving about 40% of revenues from outside its home market, a big slice from Latin America.

One of Yang's top holdings is South Korea's Samsung Electronics. "Samsung is a global IT [information technology] company that happens to be in Korea," he says. "Its products are very competitive globally, yet it's one of the cheapest IT companies in the world, trading at about 12 times earnings [when interviewed]. "
    Besides thinking globally, international investors should buy local businesses in foreign countries. For one thing, owning companies catering to the local trade provides diversification from multinationals affected by global markets or generating significant U.S. dollar-denominated revenues. It's also a way to capitalize on the growth of a nascent economy. Two widely held financials are Kookmin Bank in South Korea and OTP Bank, a Hungarian bank that's a play on Eastern Europe, according to Lyons. "Both are involved in lending and mortgages, two things that should do well when an economy prospers," he says.
    To Fries, the emerging markets are where you want to be, "in part because they have farther to catch up. Places like China, India, Eastern Europe, Russia, and even Latin America offer the best opportunities," he says. Think about what's happened to cell-phone proliferation in Russia as a case in point. Couple years ago, 40% of the population had cell phones. Today it's probably 65%, Fries estimates, although he adds that the penetration rate in nonurban areas remains quite low so there's still opportunity.
    Yang over-allocates to South Korea, which he believes will continue to prosper despite the Korea Composite Stock Price Index's 32% run-up this year (through October 24) and on the heels of double-digit returns in 2003 and 2004. "Many good companies in South Korea are still trading at large discounts to their global peers, and they're growing faster," Yang says of the Chinese trade-partner. "South Korea has more way to go."

Despite the Internet Age, gathering information on small foreign companies remains a challenge. "That's why in emerging markets, it's essential to have an experienced manager with an exacting research bench that's willing to go the extra mile," says Lyons.
In the developed markets, Europe appears attractive for reasons including cheap valuations. "One manager tells me that many European stocks are three-quarters the price of U.S. stocks, and that even though they may be growing more slowly, they represent better value," says Lyons.

Also favorable for European stocks is the corporate restructuring that's going on there. Like many U.S. companies did some years back, European businesses are cutting costs, implementing technology, divesting noncore subsidiaries, focusing on return-on-equity and generally shaping up. "That has just started to pick up in a big way in Europe," Yang says.
    Meanwhile in Japan, it's the same old story: Things are improving. Finally. Slowly. Maybe. At any rate, Fries eyes opportunity in financial services. The Japanese are big savers, don't forget. "They have large cash balances," he says. "That's an area to pay attention to."