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|  | DECEMBER 21, 2005
Investing Trends to Watch in 2006BusinessWeek's Mara Der Hovanesian sums up the yearend outlook, pointing to large caps and growth stocks as major themesOf the trends that will shape the investment world in 2006, two stand out in BusinessWeek's yearend investment outlook, according to Mara Der Hovanesian, BW's banking editor: a shift back to large-cap stocks for market leadership and a move from value to growth as the investing strategy of choice. The consensus of market strategists surveyed by BW is that the Dow Jones industrial average will close 2006 at a predicted 11,556, higher than its peak at the top of the tech bubble, Der Hovanesian reports, with the Standard & Poor's 500-stock index ending 2006 at 1,347. The sectors that look most promising in the outlook are technology, telecommunications, and health care. Tech looks good because of corporate spending, BW's reporting shows, and telecom because restructuring will be paying off. These were a few of the points Der Hovanesian made in an investing chat presented Dec. 15 by BusinessWeek Online, in response to questions from Jack Dierdorff and Karyn McCormack. Following are edited excerpts from this chat: BusinessWeek is just out with its annual yearend double issue on the investment outlook. Mara, what are its broad outlines? The broad outlines are that investors have cause to be optimistic, as the economy will continue to be strong. Profits will be as well, and therefore the markets are expected to provide good returns. What are the major themes investors should watch for? There are two biggies. One is the change in leadership from small-cap stocks to large-cap stocks. Small-cap stocks have outperformed large caps for seven years now, and even though every year the pundits keep calling for a change, this year it seems more promising because the profit outlook is slowing. In addition, real interest rates are rising. Those two forces tend to favor large caps, and they're happening now in earnest. The second major trend is that growth will overtake value, which has also performed well in the last handful of years. The same factors are driving that, as well. Any sectors to spotlight as most promising for 2006? Believe it or not, technology and telecommunications, as well as health care, are three sectors that our sources tell us will outperform in 2006, for various reasons. Technology, primarily because of an increase in capital spending -- finally -- from big business. Health care primarily because of valuation issues, and telecom because certain sectors are finally seeing the payback from serious restructuring. There are also some good Internet media plays, like 24/7 Real Media (TFSM ), as well as Google (GOOG ) and Getty Images (GYI ). Those last few are more along the lines of Internet advertising, sales, and infrastructure. What are the promising areas in health care? We're saying big pharma because of valuation issues. A lot of these -- Merck (MRK ), Pfizer (PFE ), etc. -- have had huge public relations issues with devices that haven't been working, patent issues, FDA issues, and the like. So those have all had a huge impact on the stocks for the last few years. But there are others like Medtronic (MDT ) and Aetna (AET ) (not really a pharma, but certainly a beneficiary of the demographics) that interest us. In our growth package, we've got some people picking UnitedHealth Group (UNH ) and Teva Pharmaceuticals (TEVA ). Teva is a global generic- drug maker that's expected to take advantage of drugs coming off patents. With interest rates seemingly near a peak, what about financial stocks? Yes, financial stocks are expected to do well in the coming year, with some caveats. We've got the big banks like JPMorgan Chase (JPM ), Wells Fargo (WFC ), etc., among our top picks, but we've got a lot of people feeling a little cautious about regional banks and mortgage lenders who overextended themselves in the booming real estate market. So it's a mixed bag. Also, some investment banks that have had incredible runs in 2005 because of fixed-income trading could find themselves challenged in the next year if bonds underperform stocks, as we expect. Any other investment areas look good to the people BW has talked to? One of our stories is focusing on companies that have a good pipeline of patents, so we actually called for the most innovative companies out there with the best R&D. These are smart companies looking to capitalize on the next big thing in their particular area. Not surprisingly, these are mostly in high tech and biotech, such as Microsoft (MSFT ) in software, also smaller companies like KLA-Tencor (KLAC ) and a company called Garmin (GRMN ), which does GPS products. BusinessWeek screened for stocks with high yields as well, like ConAgra Foods (CAG ), BellSouth (BLS ), and Washington Mutual (WM ). We also screened for companies that are the most underappreciated, and by that we mean companies with low price-book and low price-earnings ratios. A few of those are Ashland (ASH ) and Nash Finch (NAFC ). What's the outlook for bonds? Fixed-income investing is going to be a little challenging in 2006. Probably the best years are behind us. In general, people are still staying pretty short term because we're not over the hurdle yet in terms of what the Fed is going to do, and we've got a new Fed chairman in February. Most bond managers are recommending high-quality bonds -- it's not a good time to take on risk in the corporate arena. What's triggering the shift from value to growth? Growth of the economy itself is predicted to slow a bit, isn't it? Yes, and that's what precipitates the transition actually, because when economic growth slows and profit growth slows, investors are willing to pay up for whatever growth is out there. So rather than looking for companies that are undervalued, they look for companies that already have good growth in the hopes that they can get a piece of that. Whatever growth is out there will attract a premium, so that will drive up the price of the stock. What's the outlook for the real estate and housing market? Still pretty good, surprisingly enough. It's true that real estate and housing have been on fire, and it's harder to find value in homebuilders and REITs that invest in housing, as opposed to hotels and office complexes. While some geographic markets are surely overpriced and frothy, there are still some good fundamentals in place. For instance, even if interest rates go up this year, mortgage rates probably won't exceed 6% or 6.5%, and in previous markets it has taken rates around 8% or 9% for there to be a major falloff in demand for refinancing and new mortgages. So it forces people to be more selective about what they buy, but more people than not are skeptical about the bottom actually falling out. Did BW collect any forecasts of what might happen to the major market indexes in 2006? We did. For every yearend investment guide we always poll dozens of strategists from all across Wall Street. This year, the consensus is that the Dow, by the end of 2006, will hit 11,556, which is higher than it was in the peak of the tech boom. The S&P is expected to close yearend at 1,347, while the Nasdaq is expected to close at 2,428. Incidentally, the Russell 2000 index for small caps is expected to close the year out at 717. Are there any alternative investments that should be checked out? Alternative investments? Well, there's a great story about art collecting in the current issue. There seems to be a lot of interest in hard assets and tangible assets, and, of course, this is a very, very tricky and high-priced world. So we're offering up some suggestions for people who are getting into this arena, like make sure you stick to your spending limits, and don't get caught up in the frenzy of speculation. These are pretty basic, but it's an easy thing to get caught up in excitement. At least it's a lot more interesting than bonds. Another thing that's not necessarily an alternative investment, but shows signs of having a lot of deals next year, is private equity. It's a hot area and will continue to be. We talk a little bit about the trend driving it. We're not suggesting particular funds, but the players should be quite active next year. Will 2006 be another good year for dividend-paying stocks and for dividend increases? Absolutely. Companies paid about $200 billion this year in dividends -- this was a record. Our expert at S&P, Howard Silverblatt, tells us the trend is a lot more cash on companies' balance sheets, which benefits dividend-paying stocks. Also more activist investors are out there pushing for companies to share their wealth, so overall, yes, dividends are a big theme for 2006. Based on the positive views for growth, large-cap, and tech stocks, are the pros recommending the usual suspects in tech like Microsoft and Intel (INTC )? Yes, Cisco (CSCO ), Microsoft, Xerox (XRX ), Yahoo! (YHOO ), and Google are all making the list, but what might be more interesting, according to our Internet reporter, Tim Mullaney, are stocks that are poised to capture new media dollars as publishing moves from paper to online. In this scenario, some companies are making the most of this transition. These include Apple Computer (AAPL ), which is innovating in online music and video; Disney (DIS ); and a company called aQuantive (AQNT ), one of the largest Web ad agencies. What about energy -- the sector that hits all of us at the gas pump and the home heating system? Energy is still a good sector to invest in next year. Most of our forecasters didn't see prices of oil necessarily going through the roof, but there's a lot of demand, especially in emerging markets, where there's a lot more manufacturing now. This is also an area where there should be a lot of consolidation. So these are the two trends driving oil and gas. Two of the companies include Baker Hughes (BHI ) and Chevron (CVX ). 
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