Investment Strategy for 2006

Investing Environment

Presidential Cycle

2006 is a year 2 of the US Presidential election cycle: the worst one with lowest returns and highest volatility.

Interest Rates

The Fed has been increasing interest rates steadily for 2 and half years now.

Valuation

Using the simple Beat the Dow with Bonds model (similar to the Fed model), here is what we have as of December 30, 2005:
  • S&P500 PE = 19.7 (source MarketWatch) so S&P500 Earning yield is 1/19.7=5.08%

  • 10 Years Government Bond = 4.4%

Valuations are somewhat attractive as SP500 Earning yield is greater than the 10 Years Government Yield. Beat the Dow with Bonds would be investing in the Dogs of the Dow stocks (see below).


So we have 2 negative indicators (Interest Rates, Election Cycle) and 1 positive (Valuation). Now, the combination of increasing interest rates and year 2 of the presidential election cycle leads to poor returns historically (*).

(*) Note: 2005, which falls into such combination, without being a bad year was nothing to shine about.
The Dow lost -0.6% while the S&P500 gained 3% (excluding Dividends so total returns would be about 2% better)

Overall, 2006 sets to be a challenging year.

Waiting for the Bottom

Year 2 of the election cycle usually offers a good buying opportunity as major bottoms have historically taken place at that time: the market would then climb during the exceptional year 3... whatever the interest rates environment or market valuation !

When such bottom will happen ?
Mechanical Investors don't try to guess, they apply rules that have historically worked because that's about the best we can do.

Therefore October/November should be a good time to start buying shares (Beginning of the Best 6 months period).

Investing style

We know that Small Caps typically beat Large Caps (over long periods of time). However, Data Driven Investing found a period when Large Caps beat Small Caps. This is precisely during the combination of early years of the election cycle (years 1 and 2) and aggressive increase in interest rates.
Because the rates have climbed from a low of 1% to 4.25%, we can call this aggressive.

Data Driven Investing calls such periods the "Panic Years" because of the flight to quality to larger safer companies.
They also found that Value and Relative Strength was important in such environment.

Conclusion

  • 2006 sets to be a challenging year for the Stock Market. You may lighten up on shares.

  • Large Cap Value should be preferred (Dogs of the Dow falls in this category).

  • If you like volatility, add Relative Strength to the mix.

  • Watch out for a Buying opportunity in October/November.

2006 Dogs of the Dow

The simple Dogs of the Dow mechanical strategy is a good pick for this year. Here are the 2006 dogs using MSN Deluxe Stock Screener.

Symbol Company Name Dividend Yield (%) Price
GM GENERAL MOTORS 10.5 19.42
VZ Verizon Communications 5.4 30.12
MRK MERCK AND CO INC 4.7 31.81
MO ALTRIA GROUP 4.3 74.72
PFE Pfizer Inc. 4.1 23.32
C Citigroup Inc. 3.6 48.53
DD DU PONT DE NEMOURS 3.4 42.5
JPM JPMorgan Chase & Co. 3.4 39.69
GE GENERAL ELECTRIC 2.8 35.05
KO The Coca-Cola Company 2.8 40.31


I wish you a great 2006 Investing year.

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