Stocks should be doing better. After all, 2005 corporate earnings have been great. The war in Iraq and Gulf Coast hurricanes seem to have barely scratched the economy. But equity investors behave like careworn insomniacs at 3 a.m., their racing minds jumping from one worry to another.
Will energy prices keep rising? What if the housing bubble pops? What if the Federal Reserve's short-term interest rate hikes push the economy into a recession? Ballooning budget and trade deficits and zooming consumer debt also nibble at their minds. Then there's the possibility of another financial implosion like Enron or Long Term Capital. Or what some strategists call "exogenous shocks" — bird flu or another terrorist attack in the United States.
Before stocks can have a dramatically good 2006, Wall Street needs to shed its fears. But don't bank on that happening.
The big investment firms sure aren't. Strategists' 2006 predictions for stocks range from tepid single-digit increases to a handful of highly qualified hopes for a mid-teen jump.
"What's going to get it really moving on the upside? A lot of the factors that would get things moving have already occurred," said Tim Hayes, global stock strategist at Ned Davis Research in Venice, Fla. "Now we're vulnerable to disappointment."
Investors have bid stocks higher since Ben Bernanke was named Alan Greenspan's likely replacement as Fed chairman in late October. An early 2006 end to interest rate hikes is already priced into the market, Hayes said. And the bounce stocks have gotten in the fourth quarter has left little room for growth, he maintains.
"The issue for the market is just to relieve some of the fears we have," said Milton Ezrati, a senior economic strategist at the money management firm Lord Abbett. "The fundamentals have been superb, earnings have been above expectations, corporations are swimming in money. But we have a litany of fears that have affected and infected investors."
What would it take to push stocks higher?
The top item on most wish lists is a clear signal that the Fed's hikes in short-term interest rates will end. Historically, the end of a rate-hike streak has almost always pushed stocks higher.
The second wished-for condition is a significant and sustained drop in energy prices, which has been one of the markets' big preoccupations in 2005.
After that, opinions scatter.
They want to see "some sort of resolution or appearance of resolution to the Iraq mess," said Joseph Lisanti, editor of Standard & Poor's weekly newsletter The Outlook. "Look at the poll numbers: People are very concerned about this right now and it weighs on them."
Stocks could also climb if corporations use their cash stockpiles on capital expenditures, such as new software, new plants or new equipment.
But hope for a cap-ex explosion is tempered by how the cash is skewed. Firms have $2.3 trillion in cash, according to Goldman Sachs Group Inc., but most cash is held by banks and other financial companies. Only $776 billion is held outside the financial sector, according to Goldman.
What could send stocks lower?
As always, there are many risks.
Investors would hate to see a significant jump in energy prices or any other sign of widespread inflation.
"Inflation is not something you can put back in the bottle very easily," Tim Hayes said. "Rising interest rates and inflation would affect corporate profits and make valuations look overdone and stocks look expensive."
A minority on the street also worry about the effect on earnings that health care costs for retirees and increased pension expenses may have. There's also a concern that expensing options could hurt companies' returns.
Then there are the monster worries: What if the government raises trade barriers? What if the dollar collapses? What if consumer spending falls off a cliff?
That's why "the biggest '06 surprise could be a very powerful market move to the upside," Tobias Levkovich, chief U.S. equities strategist at Citigroup, said in a report.
There are those who see investor gloom as the best sign of all.
The very subdued expectations for 2006, could be "the perfect psychological backdrop for a bull market," said Ned Riley, chief investment officer of Riley Asset Management in Boston.
"When people are pessimistic or very guarded, they really don't commit," he said. "They're always waiting for some sort of sign or signal to invest money. Unfortunately, professionals and amateurs alike are very lemming-like in their approach."
If they get that sign, watch out. If they don't, look for flattish days ahead.
