Pearls of Conventional Wisdom

This makes it a good time for my annual survey of conventional wisdom, since conventional wisdom so often turns out to be wrong. I'm not blindly contrarian, since it can also turn out to be right. But I recognize that it's much more profitable (and takes some courage) to bet against the crowd when the crowd turns out to be wrong than it is to go along with the herd.

This year, three main themes have surfaced: U.S. markets are fully valued if not overvalued, and emerging markets offer the best opportunities for 2006; the real-estate market is slowing if not declining, which will sap consumer confidence and spending; and long-term interest rates will remain low and possibly decline as the Federal Reserve ends its tightening campaign.

Before I turn to the implications of these themes, let's review how the conventional wisdom of 2005 turned out. The results were, at best, mixed. The overwhelming expectation a year ago was that the dollar would continue its decline against other major currencies, and that long-term interest rates would rise. While 10-year Treasury yields managed to end the year slightly higher than where they began, the dollar gained nearly 15% against the euro.

While I had my doubts about the forecast of a declining dollar, I, too, endorsed the likelihood of higher interest rates, as did nearly every economist. Nonetheless, my decisions to avoid bonds and continue to increase my exposure to foreign markets, in expectation of higher interest rates and a lower dollar, turned out to be good ones. As I've noted before, you can be right for the wrong reasons.

Although interest rates didn't rise as much as expected, they did climb modestly before giving back most of the gains late in the year. There was no bond rally to speak of, certainly nothing that I or anyone else who stayed out of longer-term bonds would regret missing. Foreign markets generated stellar returns as growth surged in emerging markets and Japan showed renewed vigor after its long slump. Returns would've been even higher with a weaker dollar, but who needs to be greedy?

Even so, I'd rather make money for the right reasons, and being wrong can also be costly. Fortunately I don't trade currency futures, unlike Warren Buffett, who disclosed last year that he'd bet heavily against the U.S. dollar. I wonder what he'll have to say to Berkshire Hathaway (BRK.A) shareholders about that move.

This year I agree with the conventional wisdom that emerging markets are undervalued and offer good opportunities, even though they've already rallied strongly in the first week of 2006. The case for growth is simply too persuasive and price/earnings ratios too reasonable, which isn't to say there won't be some bumps along the way. Russia had one of last year's best-performing foreign markets, but its ill-considered decision last week to cut off natural gas to Ukraine, in turn threatening supplies to Western Europe, was a reminder of the risks of investing in a country where both democracy and the rule of law seem fragile. Should the greenback falter, as many expect, foreign returns will also get a boost in dollar terms. Because of the strong recent rally, I'd wait for a pullback to add to my exposure in emerging markets.

Where I disagree is that U.S. markets are overvalued. During the past two years, which saw only modest advances in the S&P 500, corporate earnings surged 40%. The forward P/E ratio of companies in the S&P 500 was just 15 at the end of the year, the lowest level since the mid-1990s. With profit growth expected to continue, albeit at a somewhat reduced pace, U.S. stocks look like relative bargains.

As usual, some sectors are likely to do better than others. With oil prices stabilizing and inflation low, it's hard to imagine that oil and natural-resource stocks will equal or surpass their spectacular 2005. I'll go out on a limb and say that two of the most despised sectors, media and pharmaceuticals, will outperform the averages. I've been wrong about pharmaceuticals before, but how can 2006 be worse than 2005, with its continuing fallout from the Vioxx and Celebrex debacles? I see continuing strength in telecommunications and technology, as companies boost capital spending.

The American consumer has been down for the count so many times — sapped first by too much debt, then high gas and energy prices, and now by the expectation of falling home values. Sooner or later there will be a housing correction of some sort, but I don't expect it to be severe. My own suspicion is that the "wealth effect" — the willingness of consumers to spend when housing prices are rising, and cut back when they aren't — is largely unproven. Consumers have kept spending through thick and thin, and I expect them to keep on doing it. If they want a new flat-screen TV, as Best Buy's (BBY) recent results suggest they do, they'll find a way to buy it. For now I'm holding on to my consumer-staples ETF, Consumer Staples Select Sector SPDR (XLP).

Having been wrong so many times on interest rates, many pundits are now throwing in the towel and saying low long-term rates are here to stay for the foreseeable future. No one I know is predicting a sharp drop in 2006, but they're not seeing a significant increase either, especially with the Fed's recent signal that it might be near the end of its campaign to raise short-term rates. It makes little difference to me, since I'm continuing to park my fixed-income money in safe, short-duration CDs, which offer about the same rates as longer-term Treasurys thanks to the flat yield curve. But I wouldn't be surprised to see long-term rates increase even if the Fed does end its tightening campaign. That would produce a more "normal" yield curve, ending the recent speculation about an imminent recession.

So on with 2006. A year from now, we'll know for sure whether the CW was right or wrong.