As 2006 begins, I'm at the bottom of the barrel, bringing up the rear, and the proverbial low man on the totem pole ... and I'm not talking about being in the doghouse with the Mrs. for excessive partying on New Year's Eve.

Rather, I refer to having the very lowest market prediction -- and by more than 2,000 Dow points (!) -- in the 2006 Business Week market forecasts.

In this column and one to follow, I'll describe my top down, macroeconomic process, and how I derived my improbable forecast. I'll also review some market history and explain how, after all the arguments have been made, these long-term charts reveal the most compelling reason to be cautious on U.S. equities into 2006.

If I were a weatherman, my forecast would be 50% chance of heavy showers --- despite the "sunshine" that greeted investors on the first trading day of 2006.

War Games

As part of their strategic planning, the Pentagon plays out various military scenarios: A land war in Europe, a U.S. invasion of Iraq, a revolution in South America. During the Cold War, Strategic Analysis Simulation was the mother of all war games, modeling nuclear confrontation between the U.S. and U.S.S.R.

These exercises allow for multiple variables and outcomes: Winning was less important than teasing out how different scenarios could unfold. Strategic planners wanted to learn how decisions were made in the field, where surprises may develop, how unforeseen events could cause a "domino effect."

I used similar war-gaming techniques to consider what might happen next year. Only instead of nuclear conflagration, I think about consumer spending, corporate expenditures and hiring. What might happen to real estate prices, and how will that impact other elements? Will the demand for commodities continue to increase? Will Asian growth stay strong? What will Congress do: taxes, spending, deficits, politics? What are the political wild cards? I wonder how inflation will impact all of it, and what the Federal Reserve might do, including the expected -- and the unexpected.

Barry fielded some tough questions on his thesis from TheStreet.com's Aaron Task. To watch the video, click here .

While doing all this war-gaming, one scenario kept coming up repeatedly: The slow-motion slowdown. It starts with the consumer, who after years of spending, finally tires. Soon, it infects corporate revenue and profits. Slowly, it cascades its way across different sectors: housing, durable goods, discretionary spending, entertainment. Eventually, the decay spooks the markets.

The Crowd Is Bullish

There is a lot of anecdotal chatter about sentiment , but I prefer to stick with quantitative data. I hear too many people say, "All my colleagues/friends/brother-in-laws are (fill in the blank)." That's meaningless.

The Business Week survey reveals one group of bullishness. When I made my guess, I never figured I would be the outlier to the downside. Silly me.

One alternative to conjuring up various scenarios would be to simply extrapolate this year into next. I suspect that's why so many forecasters cluster around the same numbers. Most of the surveyed group is clustered between 11,000 and 2,000 (about plus 5%-10%) on the Dow, while advising a 40% to 75% U.S. equity exposure.

But its not just the Pros: Other surveys reveal a similar bullishness. A WSJ.com poll of more than 5,000 people taken on Dec. 30 shows 46% expect the same thing in 2006 as the market gurus: between Dow 11,000-12,000. Another 12% think we end up at more that 12,000. About 22% expect to end 2006 unchanged. Only 9% expect we will see the Dow between 10,000 and 10,500 -- a mild correction of less than 10%. Just 11% believe the Dow will drop below 10,000.

This means 89% of these WSJ readers do not believe 2006 will be a substantially down year.

Note that the crowd isn't extremely bullish, however. It will take one more rally toward 11,000 to get investors to breathlessly embrace the market. Then the trap door gets sprung.

I understand why the crowd is so bullish. The past few years have seen terrific data points: S&P 500 earnings have grown by double digits for 14 consecutive quarters. Companies are awash in cash; they have been buying back shares at the most rapid rate we've seen since the late 1990s; more than $456 billion worth in 2005, according to TrimTabs Investment Research. Since the dividend tax rate was slashed to 15%, the number of companies issuing dividends has increased, and pre-existing yield-payers have upped their dividends significantly. That's before we get to the record-setting M&A activity last year.

Despite all of these elements, the markets are essentially unchanged. Look at any U.S. index for the past one or two-year period -- or even four or five -- and there's been very little progress made. Except for the pre-Iraq war selloff and subsequent snapback, and the rally from the October 2005 lows, there hasn't been much of a market gain. Aren't you curious as to why that is?

Source: TheMessThatGreenspanMade

I'd be a lot more bullish about prospects for U.S. equities if companies were plowing that half a trillion dollars back into R&D, hiring and spending. Instead, I am bewildered at the dearth of innovation in much of America's corporate suites. (Thank goodness for Google ( GOOG) and Apple ( AAPL)!)

Reality vs. Headlines

I've discussed this repeatedly: The economic data are actually far more discouraging than the headlines would have you believe:

  • Unemployment has fallen to 5% primarily due to labor pool dropouts (3.5 million at the peak; now 2.3 million) -- and not a surge of people getting jobs, as detailed here ;
  • Private sector job growth has been 0.8% since the recession ended. At this point in prior recoveries, job growth averaged about 8.8% -- and has never been less than 6.0% before, according to the Economic Policy Institute.
  • Inflation appears more benign than it actually is. Putting aside the foolishness of the "core" rate, the key reason is Owners Equivalent Rent. If housing were appropriately calculated, then CPI would be closer to 5.3%, as detailed here .
  • GDP and consumer spending have been propped up by mortgage equity withdrawal (MEW); Typically, MEW accounts for 0.25 to 0.50 GDP points. Over the past four years, the MEW accounted for about 90% of GDP -- between 2.5 and 3.5%, according to the blog Calculated Risk Without MEW, GDP isn't 4.3% -- it's less than 1%.
  • Big Old Jet Airliner

    Imagine the markets as a four-engine jet. Let's name the four engines M&A, buybacks, dividends and earnings growth.

    Our jet is cruising along at ... oh, let's say 10,847 feet. All four engines are at full throttle. Yet for some reason, the plane cannot seem to make any altitude. Every time it gets near 11,000 feet, it seems to stall. Once or twice, it even swoops down to gain some speed but still cannot seem to break that altitude.

    Mind you, all four engines are working at peak efficiency, and have been burning high-priced jet fuel prodigiously. The pilot and crew are experienced, and everyone wants the jet to go higher.

    Yet it cannot seem to make any upwards progress. Odd, isn't it?

    Now consider this: What happens if something goes wrong? What if one of the engines flames out? What if we start running low on fuel? Or if there's a human error? This doesn't mean the plane will plow into the ocean -- but it is likely to lose some altitude.

    That's the situation we have found ourselves in. Despite the many positives we have seen in the market, we have been unable to make any progress. And, if any of the positives falter slightly, markets will feel the impact in a big way.

    Tomorrow: Long-term cycles, trading ranges, and P/E mean reversion.
    Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm's variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media. Ritholtz is also president of Ritholtz Capital Partners (RCP), a New York based hedge fund. RCP is driven by the analysis performed by Ritholtz Research. Ritholtz appreciates your feedback; click here to send him an email.

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