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December 22, 2005

Choosing Up Sides
by Ron Ellison

"How could I have been so far of base? All my life I've known better than to depend on the experts." - John F. Kennedy after his Bay of Pigs Cuban fiasco.

The lines are being drawn, the sides shaping up and the ballots casts. Just what can investors expect in 2006?

Will the U.S. dollar lose some of the recent wind beneath its 2005 wings? Will GDP stumble into a recession owing to all the Fed rate hikes? Will corporations cut their hoarding and crank up capital spending? And what about world stock markets? Will Japan and all those emerging markets investors and hedge funds have been pouring money into remain hot? And here at home will large capitalization or small caps win the day? Or will it be growth versus value? Gold just hit a quarter century high. What's up there: panic buying by the Japanese to hedge against a falling yen or real inflation fears?

Does an apparent end to rate hikes generate a feel good factor among investors akin to those heady pre-2000 days, bringing more players back into equities? Where will energy prices go in 2006? And what about a housing market many maintain has been overheated for years? The National Association of Home Builders' index for sales of new, single-family homes dropped in December to 57, it's lowest level since April 2003.That's down from a revised 61 in November after the index was first reported at 60. Any number above 50 is supposed to mean more builders see the home building glass half full. New housing starts hit a 33-year high in 2005, up on an annual basis for the fifth straight year. Could 2006 clock in for a sixth consecutive gain?

And don't forget there is always the convoluted world of politics, not to mention a war that many Americans seem to be tiring of. What surprises lurk there? If China fails to revalue its currency does Congress do something stupid, kicking off a trade war? And what about pricing power? Will it just continue to be a business-to-business affair or will it trickle down to the consumer? And will real wages continue to go nowhere?

Some folks laud the market's performance given all the negative factors it faced in 2005, arguing that with any sniff of good news the market should soar. Could it be that the market, perverse animal it sometimes is, digests the so-called good news by heading south? And if you like indicators, what's this one saying? Market sentiment numbers show more bulls among investment advisors every month for the last three years, the longest such skein ever. Yet the current bull market, if that's indeed what it is, is three years off its low. And there is volatility, sometimes viewed by many retail investors as their worst nightmare, a no-show these last two years.

Growth over the last two and a half years has averaged four percent with no quarter falling below three percent despite several natural disasters, oil prices that doubled, 13 Fed rate hikes, natural gas prices jumping 47 percent year to date, the expectant retirement of the Maestro Man and a huge trade deficit among other things. How much greater Wall of Worry do those who subscribe to the idea that stocks always climb a Wall of Worry want? Or is there such a thing as a Wall of Whoopee, having discounted all the good news by the time retail investors get the picture focused?

In November Bill Gross, the Pimco guru, was quoted as saying: "We are due for what appears to be a 2% or less GDP growth rate in 2006, a rate sure to stop the Fed and to induce eventual ease as some point later in the year." Gross also apparently expects the dollar to weaken in 2006. Years ago there was a popular song about a young girl who dreams of running off someday with her rodeo-chasing boyfriend. At one point the girl reveals that when her boyfriend "comes a calling my father ain't got a good word to say." Well, Gross, though bond maven that he is, apparently ain't got much good to say about equities for 2006. And neither does another market guru, Jim Rodgers.

Ed Keon of Prudential Equity Group is pushing a different tact. He turned bullish with a big B for 2006 earlier this year and expects equities to make bonds 2006's orphans. Keon claims stocks are undervalued versus bonds. He cites a repeat of the 1995 scenario when investors rallied to the stock market after avoiding equities. So Keon's view has a catch-up element, claiming retail investors once they see the light will jump back into the market with both feet and their checkbooks.

A few of the things that typified 2005 - leveraged buyouts, increased dividend payouts and stock buybacks, all benefiting equity holders - could take a leave of absence in 2006, but not without hurting the bond market and corporate credit ratings. Recall after 2000 corporations became hell-bent on repairing their balance sheets and returning value to equity holders. Repairing balance sheets is supposed to succor bondholders. For the most part it hasn't happened. So the shootout at the Corporate Corral between equity and bondholders could continue, according to some market gurus, further hurting corporate bonds.

Paul Kasriel of the Northern Trust Company poses an interesting question. Kasriel maintains that corporate borrowing among non-financial companies though it has slowed somewhat continues at a rather robust pace, this in spite of generating reams of internal funds in recent quarters to the tune of 125 percent of capital expenditures, close to record levels. So why, Kasriel asks, flush with all this cash is corporate America not paying down debt and increasing capital spending? If the term equity buybacks comes to mind, according to Kasriel, you're on to something. However, if the economy downshifts later next year, Kasriel notes, that shootout at the Corporate Corral could leave a lot more corpses on both sides than currently expected.

And now according to a recent study by one Boston-based fund management group, companies are, owing to shareholder pressure and changes in the tax code, expected to increase their payout ratios for dividends until the year 2010. During the go-go, Internet-bubble years dividends got whacked as companies opted to reinvest their funds and push capital gains. At 32 percent, the current payout ratio is well below historical norms. Since 1936 the average dividend payout ratio has been nearly 54 percent. There is also increased pressure for non-dividend paying companies to start doling out those quarterly checks. Even some of those technology wonders of the pre-2000 crash period have climbed aboard.

So if all of this leaves you feeling a bit confused, you're not alone. About the only thing clear is the experts have spoken. Your assignment, should you choose to accept it, is a simple one: Figure out which experts through their economic looking glasses see it correctly.

Ron Ellison
Blasingham and Ellison Financial Group

Ron Ellison is a principal of Blasingham and Ellison Financial Group, a money management firm in Newport Beach, California, and can be reached at www.Befg1.com.

Copyright © 2005-2007 Ron Ellison

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