A "Contrarian Lens"

01/06/2006 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

A three-tiered methodology combining traditional fundamental and technical variables with the added layer of sentiment analysis is the hallmark of Bernie Schaeffer. Here, looking through his "contrarian lens," he offers his 2006 stock market forecast.

"Crowd expectations lie at the heart of our methodology, as stock prices are largely driven by the investing public's perception of reality. Because the crowd tends to move as a herd, data such as call and put open interest and short interest can provide excellent contrary indicators. Such contrarian indicators are far more powerful when the sentiment picture runs counter to the trend of the stock.

"In other words, when an outperforming stock or sector has managed to rally against a backdrop of low expectations, the odds of continued strength are improved, as the apathy (or outright pessimism) from the investing crowd signifies the presence of additional sidelined funds. Conversely, high expectations tend to indicate that anyone wishing to invest in a particular stock or sector has already done so. Buyers are few and far between, and the slightest nugget of negative news could catalyze a decline. With this methodology in mind, let's look ahead to 2006.

"The past few years have seen a slow decline in earnings growth for S&P 500 companies and the average estimate among Wall Street economists is for 2006 earnings growth of 12.6%. This forecast has the potential of being far too high, as it assumes several risk factors will be non-events. The potential for inflationary pressures are barely acknowledged, Fed rate hikes are expected to slow (they may not), and the potential negative effects of a flattening or even inverting yield curve are virtually ignored.

"From a risk-to-reward perspective, I'm concerned by the easy dismissal of these risks, which have historically been detrimental to the economy, and which I feel might play a role in the economic landscape of 2006. Even if it's smooth sailing as the Fed expects, I see little upside for the blue-chip and mega-cap stocks, as many have already invested for a strong 2006 economy. If I'm correct about these risks, sub-par economic reports could result in a sell-off far more dramatic than any upside that might transpire. In short, because of the expectations currently in place, the returns possible if the economy does thrive do not compare, on a relative scale, to the potential losses.

The Bottom Line

  • Blue-chips and the mega-caps will be the most vulnerable sectors heading into 2006. This is where there is little upside and major downside, where ridiculously cheap option premium is sold, where people are over-investing because Wall Street describes these names as "safe," and where a market crash would wreak the most havoc. The mega-caps have terrible risk/reward ratios, regardless of whether or not a gloomy economy comes to pass. If economic factors disappoint in 2006, these ‘safe’ areas will plunge. If the economy lives up to or exceeds current expectations, these areas will severely lag the underloved, oversold small-caps, which should soar.

  • There are many high-profile risk factors as we move into the second half of the decade rising oil and other commodity prices, a new Fed chairman, a tight labor market, and the ever-present concerns from a geopolitical landscape, to name a few. But the overall conclusion among economists and investors is that many of these factors are non-issues, wild cards, or somebody else's problem. Once again, there is much uncertainty heading into 2006, and I urge investors to navigate this environment through sector plays versus broader-market index investing.

  • While the probability of a crash is always low, I believe the odds of one happening are greater this time around than they have been in recent years. And I anticipate that 2006 will offer some frustration to the bullish contingent. Increased volatility may supply more profitable opportunities this time around on both the bullish and bearish sides, but these winning periods may be short term in nature.

  • Hedge-fund activity will continue to affect the market, causing rapid sector rotation. This will reward the nimble investor, while the ‘buy and hold major index funds’ crowd will likely underperform.

  • Going into 2006, if you are fully invested, ensure you have portfolio insurance through the purchase of index puts, which are currently cheap. Otherwise, keep a strong cash position of about 25%. Focus your portfolio on small caps, financials, energy and utility concerns, and gold. Keep retailers and housing in mind should the doom-and-gloom economic variables fail to assert themselves.

  • I remain wary of large-cap names, particularly in the technology sector. Equities such as Microsoft and Dell remain widely loved, without the fundamental or technical backdrop to justify such affection. This leaves these stocks, and others like them, very vulnerable. Also avoid large-cap blue-chip favorites such as General Electric, Wal-Mart Stores, and Pfizer."

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