Happy New Year !

We begin 2006 with some trepidation about the short term, but also with some excitement for the potential strength in stocks by year’s end.

We anticipate the start of 2006 to bring with it some bumps and bruises and we plan to start the year in a similar posture to our late 2005 posture, which is defensive.  Unfortunately for us at TSP Talk, we had anticipated this weakness to come prior to the new year and it cost us from participating in the late 2005 rally. 

Small caps and international stocks did well again but it wasn’t really an outstanding year for stocks in general - The S&P 500 was up 3.00% (The C fund was up 4.96 %) in 2005.  The Dow was actually down 0.61%.  And the Nasdaq was up just 1.37%.  We spent much of 2005 in defensive mode because our indicators were telling us that it may not be a great year.  Even though no real harm was done to stocks, those returns tell us we were right to be on the cautious side.  We ended the year rather flat, being up just 0.51% in our active account but our longer term outlook suggested allocation managed a 8.50% gain. 

A bad move in late October cost us some gains in our trading account but we still feel we approached 2005 correctly.  Ironically we would have done better had we either been more conservative and stayed in the G fund more often, or were more aggressive and better utilized the S and I funds.  It seemed as if every time we stuck our necks out, like during the historically strong December holiday week, we were punished. 

The key to timing the market (not day trading) is to play defense when things are not looking right, and to get very aggressive when they are. 

We do believe 2006 is setting up nicely for a big year.  That is after we experience a pullback that will bring the intermediate term indicators closer to a buy signal.  By year’s end we foresee a strong double digit gain for the S&P 500 in 2006 – as much as 25% to 35%.  So, we are not only hoping to be a part of those big gains, but if we play it right and wait it out, we could miss any early pullback which would magnify our gains.  And after the mediocre performances of 2004 and 2005, we are really excited about it. 

Why will it be a good year?  Three reasons:  Psychology, monetary conditions, and valuation.  The first two have been in some trouble of late and have kept us in defensive mode. 

The longer term sentiment and overbought/oversold indicators, which make up much of the psychology leg, have been telling us we need a decent pullback to give investors time to refuel.  If too many people are bullish and already heavily invested in stocks, there isn’t much fuel left in the tank to keep things moving higher.  That can keep a cap on stock prices.  You want to see investors getting nervous, holding on to cash, and even doing a little panic selling as the indexes move down.  Pessimism turned to panic is what puts in major market bottoms.  We saw a little of that in late October 2005 - Just not enough to affect the longer term indicators.

The other leg of the market that has had trouble is the monetary conditions.  Rising interest rates and an inverted yield curve top that list.  The good news is that the new Fed Chairman, Ben Bernanke, is likely to pause on the rate hikes.  We are also anticipating the Fed to stop chocking the economy and to start adding to the money supply as signs of a weakening economy present itself in the early 2006 reports.  That tends to bring investors back to the market.

Valuation is the one leg of the market that has remained strong and has been the main reason why the pullbacks over the past two years have remained on the mild side.  The best way I find to decipher valuation is to compare the yields of the S&P 500 earnings and the 10 year Treasury Note.  The S&P 500 earnings yield is currently 6.64%.  When compared to the yield of the 10-year Treasury Note (as of 12/30/05, 4.39%) that makes stocks undervalued by 33.8%.  In the next few years we will see these two yields move closer together.  That will happen by stock prices rising, bond yields rising, S&P 500 earnings dropping, or a combination of the three.  So with the 10-year Treasury bond yielding just over 4% and the S&P 500 trading at just 15 times estimated earnings, the market is at its deepest discount relative to bonds in two decades.
 
In the short term we could see a little bounce early this week in stocks as the selling was pretty aggressive late last week.  But we still believe the next few weeks will continue to bring lower prices.


                                    Chart provided courtesy of www.decisionpoint.com

Some administrative notes: 

I've updated the TSP Calculators for 2006.  If you plan to track your returns this year, it's a good place to start.  I did a version with the L Funds, and one without.  I believe the L funds are a great place for most TSP investors.  That is because most TSP participants do not plan on monitoring their account over the course of the year.  TSP Talk members are different of course, or you wouldn't be reading this.  I don't plan to use the L Funds for I don't believe they were designed to trade actively.

The message board has now been converted to the new software.  I anticipate some minor problems over the next couple of weeks as we use the new features.  If you have any problems or suggestions, please contact us and we'll take care of it. 

The Longer Term Outlook Comments, which I normally update in January and July, have been updated.  Much of what I said here today is repeated their as I talk about what we should expect to see in 2006.  It will be available for review throughout the first half of the year. 

That's all for today.  Currently 50% G, 50% F fund.  Thanks for reading.