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."

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