Outlook 2006: Thomas McManus

Investment Picks
Buy: Large-cap growth companies. McManus also prefers growth over value stocks.

Avoid: Smaller companies, and stocks with high dividend yields but slow growth.

Favorite Economic Indicator: Consumer confidence. McManus says this sentiment reading offers him insight into expectations for earnings and GDP growth.

2006 Outlook
Trouble is brewing, warns Thomas McManus. The stock market is expensive, profit growth is slowing, and investors currently have little aversion to risk. And while volatility has been on the decline since 2002, it could rear its ugly head again over the coming year.

With this back drop, the chief investment strategist at Bank of America Securities wouldn't be surprised if the stock market declined 10% at some point next year. That doesn't mean all of 2006 will be a bust, however. By year's end McManus says the market should recover at least some of its losses. He expects the S&P 500 to appreciate somewhere in the midsingle-digit range percentage-wise and reach 1335; his year-end target for the Dow Jones Industrial Average is 11700.

Careful market timing is the key to success. The best opportunity to pad portfolios will come after a correction, says McManus. So investors need to have cash waiting in the wings to pour into equities once stocks pull back. With this scenario in mind, McManus recommends starting the new year with 55% of assets in stocks, 20% in bonds and 25% in cash.

"I do believe there is risk to being out of the market as well as in the market," he says. "The goal is to match up that risk, and make sure you have enough exposure without being overexposed."

Market risks in 2006 are many. Tops among them: The economy could grow faster than expected, which would force the Federal Reserve to continue hiking interest rates. Right now, McManus expects the central bank to take a breather at 5.0%. The changing of the guard at the Fed could rattle markets as Wall Street adjusts to a new chairman.

"It's our sense that the market is currently underestimating the potential differences between the policies and approaches of Alan Greenspan and Ben Bernanke as Fed chairmen," writes McManus in a research note dated Dec. 13. "Greenspan has obviously learned a great deal during his nearly 19 years at the Fed's top spot, and while Bernanke is no doubt highly intelligent and capable, he lacks the depth of experience...of Mr. Greenspan."

Another risk is the tendency of the stock market to do poorly during the middle of a president's second term. "There's no incentive for the incumbent president to get the economy [growing] during the midcycle election year," McManus says. "But it does make a lot of sense politically to try and coordinate economic strength so the economy is chugging along on all cylinders as the people go back to the polls."

If you have to put new money to work, McManus recommends focusing on quality large-cap growth names. A number of these stocks are attractively valued after five years of underperformance. Big, stable companies also tend to hold up better in a decelerating economy.

What to avoid? Chasing income for income's sake. With more than $2 billion worth of inflows so far in 2005, the iShares Dow Jones Select Dividend Index (DVY) is the single most popular domestic exchange-traded fund, easily surpassing such popular indexes as the S&P 500 and Russell 1000. But these dividend-yielding stocks come with risks, McManus argues. DVY, for example, has 60% of its assets invested in financials, telecom and utilities. And since July it has trailed the S&P 500.

Income-oriented investors should opt for companies that retain at least 55% (and as much as 75%) of their earnings to reinvest in the business. That offers a better chance for above-average profit growth. Examples of these types of companies are Procter & Gamble (PG), PepsiCo (PEP) and Abbott Laboratories (ABT).

McManus hopes investors will keep one last piece of advice in mind: If the market feels overvalued and investment opportunities are difficult to find, then don't force the issue. Better to wait on the sidelines until cheaper and more promising prospects come along.