Mark Bail gives us a 2006 Economic Forecast.

Hello again, Sleuths,

And Happy New Year! I hope you had a happy holiday season — and I trust that the year just ended was a rewarding and profitable one for you.

Alas, dear Sleuths, this is a new year. Although we don’t know for certain what will happen in the next 12 months — we do know that this year won’t be exactly like the last. For every year is different. Each year is a new chapter in your own personal book — in this case, your trading and investment book. What worked in one year may not work in the next. Trends that start in one year may continue and deepen in the next. Or reverse.

A new year is a time to get a fresh start. It’s a time to wipe the slate clean, to begin anew. It’s exciting to contemplate what may transpire in the next 12 months — and should events unfold as we foresee, how we can be prepared to take advantage of them. That’s why I said in my last Technical Tuesday column that I would discuss my outlook for the new year today.

All right, then. What can we expect to see in the market in 2006? Ah, fellow Sleuthers, I have already shared one nugget with you. As you know from my last two Penny Sleuth appearances, I believe gold will shine brightly in the next 12 months.

But what about the overall market? What does this year hold in store for the majority of equities? Those are the questions I’m going to grapple with today.

In the middle of November — as I prepared to make my way to Baltimore to attend our freewheeling, no-holds-barred monthly editorial meeting — I puzzled over just those questions. For on my November visit to Baltimore, I was not only going to share ideas and exchange opinions with my fellow editors — I was also going to be interviewed for the just-released Webinar that we were preparing for Agora Financial Reserve members. The topic I was going to be interviewed on was my outlook for 2006.

Now, I’m typically not a “big picture” guy. Unlike some of my colleagues, I generally view the market through short-term lenses. When you trade options — like we do in MST Trader — short-term price movements are your major area of focus. So I normally leave the great macro ideas to others.

But I had a great deal of fun being interviewed. And in preparing for the interview, I was able to gain a perspective on the new year I might not have had if I had just gone about my normal course of business — which is to look for short-term price movements. In this Technical Tuesday and my next column two weeks hence, I’ll share with you the conclusions I reached and why I reached them. I hope you enjoy what I have to say.

More importantly — it is my fervent wish that my comments and conclusions stimulate some of your own thinking about the financial markets in 2006.

As you read this column — and my next one — please keep in mind that I drew these conclusions during the end of 2005. However, nothing has occurred in the intervening seven weeks to alter my opinion. So let’s get on with it and ring in the new year, shall we?

Let me begin by stating my overriding conclusion for this year.

I think 2006 will be a difficult year for equities. In fact, I see this cyclical bull market that commenced in 2002 coming to an end. And I think it will happen soon — in the early part of the year.

Many of the problems you are no doubt aware of — the high level of debt in the United States, the low savings rate, the lack of real growth in the economy, the near-historically high oil prices — will all conspire to take large bites out of investor returns in 2006. Throw in the effects of an unending string of rate hikes by the Federal Reserve — 13 and counting, with another one expected on Jan. 31 — and the challenges facing the market are significant. I believe all these impediments will take their toll on returns in the coming year.

2006 Economic Forecast: Parallels with the ’70s

A number of people have made the analogy that this decade looks a lot like the 1970s. I don’t know just how closely these decades match each other, but there certainly are some striking parallels.

Both decades saw the United States involved in a controversial war in a foreign land. Oil prices moved to record highs in both the 1970s and the 2000s — causing people to suffer “sticker shock” at the pump and Washington politicians to rail against “windfall profits.” Both decades were filled with worries about inflation, rising interest rates and real estate prices and a bull market in gold.

Well, what about the stock market? The 1970s were characterized by generally meager returns, as the market oscillated in a seemingly interminable trading range. For example, from 1966-1982, the Dow Jones Industrial Average bounced back and forth between 1,000 and 500. Meanwhile, the average investor’s portfolio made very little headway. And when inflation was factored into the equation, the average investor was a net loser.

Now, I’m not saying that we’re seeing a repeat of the 1970s. From someone who remembers the days of leisure suits, mood rings, pet rocks and Disco Duck — I certainly hope not. But this decade has, so far, been the worst we’ve seen since, well, the 1970s.

Just like the 1970s, it’s possible that we’re in the midst of an environment where the major market indexes move within in a wide range –- essentially going nowhere. If that turns out to be our fate in this decade, you will be able to make some significant money if you buy in the early stages of a major up-move. But if you buy in the late stages of a bull market, your risk in owning stocks becomes significant.

2006 economic Forecast: Risk Exceeds Reward

And that’s where I believe we are now. At this juncture, I believe the risk in owning stocks greatly exceeds the potential reward one can reasonably expect to achieve.

I need to clarify one point here. When I talk about owning stocks, I am not talking about a special situation that you may learn about from one of my editorial colleagues here at Agora or that you may know about through your own work experience or area of expertise. What I am referring to is the vast bulk of stocks listed on the New York Stock Exchange or the Nasdaq Composite — in other words, the general market.

Now, why do I say that the risk of owning most stocks far outweighs their potential reward at this point in time? Let’s take a look at my favorite means of analyzing the market — the technicals.

I checked the monthly charts of three of the major large-cap market averages -– the Dow Jones Industrials, the S&P 500 and the Nasdaq Composite. I regularly monitor the short-term price movements of these three well-known indexes, as they represent most of the types of stocks whose options we recommend in MST Trader. Moreover, they pretty well represent what the financial press generally refers to as “the market.”

Well, guess what I found? All of them are stuck in multi-year trading ranges. Unfortunately for bulls, what makes things treacherous is that they all are closer to the tops of their ranges than to their bottoms.

Yes, it’s true that the market has sold off recently. But remember, we’re talking about long-term charts here. On their monthly charts, these recent pullbacks have had little effect — leaving all three averages much closer to their multi-year highs than to their lows.

In a long-term uptrend, that might be a good thing. But that’s not how these large-cap indexes appear on their monthly charts. All three appear to be stalledin the upper reaches of wide trading ranges. In other words, at this juncture, the risk of a significant move lower appears more likely than the start of another large rally.

Since many of you Sleuthers are small-cap devotees, I also took a look at the Russell 2000 Index. Unlike its large-cap cousins, this small-cap bellwether has been in a confirmed long-term uptrend since making a higher double-bottom in early 2003. However, the lion’s shares of this index’s gains were captured in 2003 — and the last two years have been marked by a noticeable slowing in upside momentum.

2006 Economic Forecast: Observing Three Indicators

If you have been reading my prior Technical Tuesday columns, you know that the trading system I employ in the MST Trader is based on three distinct technical indicators: the Slow Stochastic Oscillator, the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD). Since I have previously devoted columns to the Stochastic Oscillator and the RSI — and will discuss the MACD in a future Penny Sleuth — I won’t go into detail about any of these helpful technical tools today.

However, let me share one observation about these three indicators with you. When I studied the monthly charts of the Dow Jones Industrials, the S&P 500 and the Nasdaq Composite, something struck me about the current readings of their Slow Stochastics, RSIs and MACDs. The recent peak readings registered in the second half of 2005 by all three indicators were lower than they were at their respective early-2000 highs. And those peak second-half 2005 monthly readings in all three indicators were lower than at their respective late-2003 highs in the Russell 2000.

So although all three large-cap indexes are in the upper reaches of multi-year trading ranges — and the Russell 2000 sits just 2.9% from its all-time high — none of the three technical indicators has been able to flash the strength one would expect to see in the midst of a strong rally. Why is this remarkable? Simple. Despite their respective recent retrenchments, all four of these widely followed market averages are relatively close to intermediate or long-term highs. When a market average is close to an important high, it should be in the process of registering peak values. That’s simply not happening now.

This failure of the indicators to equal or exceed the high valuation readings registered during earlier significant highs — either at the large-cap averages’ 2000 tops or at the Russell 2000’s late-2003 intermediate peak — is what we technicians call a bearish divergence. In the context of what we might expect to see unfold in 2006, that’s very telling.

How so? Well, with those indicator values lower than they were at their prior pinnacles — it tells me that these market indexes probably lack the necessary strength to generate sufficient momentum to sustain powerful upside moves in the next several months.

On the contrary, I think the lower peaks set in the Slow Stochastics, the RSI and the MACD — coupled with the failure of each of the four market averages to decisively break out to new multi-year or all-time highs — implies that we are seeing a deceleration in the market’s upward momentum. With long-term momentum decelerating while the four major indexes remain relatively close to recent peaks, the risk of a sharp decline in the market this year is high.

Now, let’s throw in one more piece of information that underscores the risk in equities in 2006. This bull market — at nearly 3 1/4 years old — is rather long in the tooth. Thus, by historical standards, it is much closer to its terminus than its beginning — whether it still has a rally left in it or not.

Exactly how much risk is there in the market over the next 12 months? I honestly don’t know — and neither does anyone else, for that matter. As I said earlier, and as I stated in the Webinar, I think odds are good that the current bull market ends this year.

That doesn’t mean that — if I’m right — you can’t make money in the market in 2006. You can. There are always emerging new companies or stocks that soar on the promise of breakthrough technology. Or there are the undervalued or undiscovered small-cap gems frequently uncovered by some of my fellow editors.

Or you can pinpoint a sector of the market that runs counter to the tide. In the most recent two Technical Tuesday columns, I made the case that gold and precious metal issues would shine brightly in the coming weeks and months — and so far, they have. Or you can be highly selective and wait for only a certain few periods to buy stocks.

Whatever you do, 2006 doesn’t shape up as a year to buy and hold any old stock. That’s because — based on what I see on the long-term charts of these four closely scrutinized indexes — the challenges facing investors in 2006 are going to be greater than at any time in the last four years.

And speaking of four years — if I haven’t yet convinced you of the bearish environment that stocks will be enmeshed in this year — the four-year cycle also suggests that 2006 bodes ill for most equities.

What’s the four-year cycle and what are its implications for the new year? Read my next Technical Tuesday missive two weeks hence, dear Sleuths, and I’ll throw a bunch of numbers at you about how the four-year cycle also points to 2006 being the Year of the Bear. Grrrr!

Best wishes for a happy and profitable New Year! Trade well,

Mark Bail
January, 3, 2006

Penny Sleuth Contributor

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