Jeremy Siegel, Ph.D. The Future for Investors

We all know the future is unknowable, but as 2005 draws to a close I succumb to the pressure to forecast what will happen in 2006, realizing full well that this activity invites getting your head chopped off when someone revisits your predictions next December.

Bullish on Stocks

I believe U.S. stocks will have a good year in 2006, with expected total returns (dividends plus capital gains) of 8 percent to 10 percent.

The bullish story: Earnings growth rates have maintained double-digit increases for a record 13 consecutive quarters, yet stock prices have crept up much more slowly. This has compressed the price/earnings ratios of stocks, that all important measure of stock valuation.

As of December 20, estimated operating earnings for the S&P 500 stocks are $85.50. At the mid-December level of 1250 for the index, this yields a price/earnings ratio (P/E ratio) of 14.6, a very reasonable level of valuation. Even if you believe these operating earnings are overestimated by say 10 percent that still leaves stocks selling at a 16 P/E ratio.

The earnings yield -- the inverse of the P/E ratio and a good estimate of forward-looking real returns on stocks -- therefore stands between 6 percent and 7 percent. Compare this to the real yield in the bond market, which is a smidgen above 2 percent, and it's clear that stocks are "cheap" compared to bonds.

Keeping a Lid on Interest Rates

Aside from a disastrous terrorist strike, sharply higher interest rates are the only thing that could really tank the stock market.

Although long-term interest rates will creep up in 2006, the Fed is nearly done raising short-term rates. Greenspan may put forth one more rate increase in January, but Bernanke will likely hold the line at his first meeting on March 28.

Productivity gains and cheap imports will continue to restrain inflation, thereby keeping a lid on interest rate spikes. All in all, this climate allows stocks to thrive.

Finding Value in International Stocks

In my book, "The Future for Investors," I recommend that investors put up to 40 percent of their total stock portfolio into non-U.S. stocks.

Today, more than half the world's capital resides outside the United States, a fraction that is destined to rise significantly as Asia, Latin America, and other emerging markets continue to grow. While 2005 witnessed heavy inflows into foreign markets, this trend has more room to run.

In addition to the diversification benefits of investing in foreign markets, most foreign stock markets are more attractively priced than the U.S. market, with P/E ratios in Europe averaging around 13.

Foreign markets have done very well this past year, and they will continue to thrive in 2006. European stocks are up 15 percent to 20 percent in 2005, but the dollar's rise against the Euro offset about half the gain for U.S. investors. The Japanese market has surged on the hopes that the country's long, slow period is finally over. Still, I find Japanese stocks expensive. On the other hand, stocks in developing countries are on fire -- up 20 percent to 40 percent and more in dollar terms. They, too, will continue do well through next year.

Should investors in foreign stocks worry about the greenback? In the short run, it's hard to predict the dollar's exchange rate. In the long run, changes in currency values play a very small role in determining foreign stock returns. This is because stockholders have claims on real capital, whose value will change with inflation, the primary long-term determinant of exchange rates.

Energy Will Thrive

Many economists expect the U.S. economy to slow substantially in 2006 and some predict growth under 2 percent. But I'm not so sure.

Look at how well the consumer responded to the energy shock this past year. GDP growth in the fourth quarter is down from the torrid pace of the third quarter, but the fact that growth in the second half of the year exceeds 3 percent is quite impressive, especially given the disruptions of Katrina and record high oil prices.

I'm not implying that consumers are ignoring higher energy prices. In fact, I expect oil to stay about $50 a barrel or higher for the foreseeable future. Higher prices will lead to huge opportunities for firms engaged in energy conservation or searching for alternative energy sources.

Energy was the best performing sector of 2004 and 2005. But how about 2006? If history is your sole guide, energy could be headed for a slump. You see, energy was the best performing sector two years running in 1979 and 1980, only to be the worst performing sector in 1981.

But, in this case, history is not apt to repeat itself. Oil prices have not been driven up artificially the way they were a quarter century ago when the Arabs embargoed oil and sharply cut production. A fundamental increase in the demand for oil (read China and India and the developing world) will keep oil prices high and the sector will continue to do well in '06, although it's unlikely to be the top performer.

The Bottom Line

Of all major asset classes -- stocks, bonds, and real estate -- I prefer stocks hands-down.

As I've stated in previous columns, real estate has done well because long-term interest rates are still quite low. Although I don't expect rates to rise significantly from here, the increases already undertaken by the Fed means that financing has become more expensive. Housing is at or very near its peak.

Since I don't expect yields to go down (meaning bonds are not a good bet either), this leaves stocks as the asset of choice for long-term investors.