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Markets

A Winning Year for Stocks

I can see stock returns of 10% or higher in 2006. International stocks should continue to do well, too.

I felt that throughout most of 2005, the stock market was undervalued. Two main concerns kept the market down: rising energy prices and rising interest rates. But at last it looks as if we could be getting some relief on both fronts.

After Hurricane Katrina struck, we stared down an energy-price surge that rivaled increases during the Arab oil embargo of the 1970s. And guess what? We endured the high prices, adjusted our energy consumption and continued to spend. The strength of the economy in the wake of the increase in energy prices has surprised virtually all economists. Looking ahead, oil prices will stay high but below Katrina peaks.

Role of the Fed

As for the second concern, I believe that the Federal Reserve Board is almost finished raising short-term interest rates. Ben Bernanke, its likely new chairman, pays attention to the relation between long-term and short-term interest rates. History strongly suggests that if the short rate is pushed above the long rate, a recession will ensue. Bernanke will be careful not to let that happen. Long-term rates are now about 4.5%, so the Fed should be near the end of its tightening cycle.

All this means that stock investors should enjoy a good year. I can see U.S. stock returns of 10% or higher in 2006. International stocks should continue to do well, too. Economic growth in China continues apace, and now India, countries in Latin America and many other developing nations are experiencing accelerated growth. Up to 40% of your stock portfolio should be held in companies based outside the U.S.

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Despite the huge U.S. trade deficit, I expect the dollar to hold firm or even increase in value through 2006. Interest rates in the U.S. are much higher than in Europe, and they are very close to those in Great Britain, a country that usually has much higher rates than the U.S. So there is nothing to quell the enormous appetite that Asian countries have for the dollar. It's in their interest to keep selling products and entrench their goods here. Doomsayers have for years predicted a collapse of the dollar. Save your anxiety for other problems.

What pitfalls await us? A good year for stocks might be even better if President Bush can turn around his sinking poll numbers and win extension of the lower dividend and capital-gains tax brackets. Unless Congress acts, those lower rates are due to expire at the end of 2008. Bush's main problem is a perception that Iraq has turned into a quagmire, and the war effort has lost the support of the American people. If that perception continues to erode public confidence, the President and the Republicans will take it on the chin in next November's midterm elections. That could mean higher taxes and give the stock market a case of indigestion late in the year.

Bonds and real estate

These two asset classes won't fare as well as stocks in the year ahead. Long-term interest rates are not apt to decline and may even rise further. With bond yields already low, even stable rates make fixed-income investments unattractive, and rising rates make them a disaster.

Real estate, the darling asset of the past five years, is at or very close to the top. Prices have been high because interest rates have been so low. Now that interest rates have firmed, housing is already slowing down. Any additional rate increases will further slow the sector.

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All of this doesn't mean that the real estate market will collapse. But housing prices have probably reached their peak, and the froth will come off some of the more speculative markets. Because rents today rarely cover owners' carrying costs, returns in this asset class will be low if real estate prices do not rise.


Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.