WHATS HOT, WHAT’S NOT
The broad U.S. stock market is up almost 6 percent this year, but as always, the details tell a more interesting story.  Investors who loaded up on energy stocks revealed in the group’s 18 percent gain, while health care investors suffered a 4 percent loss.  Here’s a look at the year’s winners and losers so far and Smart Money’s outlook for the rest of 2006.

HOT

Industrial Metals Fueled by insatiable worldwide demand, steel-company stocks are up 76 percent.  Three of the 10 best performing S&P 500 stocks are steelmakers.  Firms that deal in other hard commodities such as nickel, zinc and copper are up an average of 26 percent.

Outlook  The past three yeas have seen the biggest bull market in commodities in five decades.  Over the long term, worldwide demand will continue to rise, but the mania over commodity firms is reminiscent of the Internet bubble.  The momentum may continue for a while, but you shouldn’t chase these winners unless your stomach is made of steel.

Construction and Farming Equipment Stocks of companies that help change the face of the land, from engineering firms to bulldozer manufacturers, have soared. 
Farm-equipment makers are up 32 percent, while companies that make building materials, like cement, are close behind.

Outlook  Outstanding profit growth has fueled these stocks, but watch out for any economic hiccups that could slow the worldwide construction boom.  Stick to diversified manufacturers, like Emerson Electric or Cooper Industries, and take profits in construction-material firms, such as drywall maker USG, which will fall harder and faster if there’s a slowdown.

Oil and Gas Equipment  Companies that supply drills and rigs to energy-exploration and production companies have minted money; they are up an average of 38 percent.

Outlook Oil’s high price has fueled w wave of exploration projects worldwide.  But the equipment companies seem a bit pricey.  Instead, consider the large integrated energy firms, such as ConocoPhillips, which trade at single-digit P/Es.

Gold The shiny metal started the year at $530 an ounce and hasn’t looked back: On May 11 it hit $725, a 26-year high.

Outlook  The three main drivers of the price of gold –rising inflation, a falling dollar and global instability –have been sending a buy signal.  But we have trouble agreeing with gold bugs who see gold hitting its 1980 high of $850, which would mean more than $2,000 in today’s dollars.

International Stocks When it comes to stock market performance, the rest of the world is beating the U.S.  The MSCI overseas index is up 19 percent, with good news from Pakistan (up 21 percent) to Brazil (up 38 percent).

Outlook  Though the easy money has been made on emerging markets, investors should remain diversified overseas, and if Warren Buffett is right, you’ll benefit as stocks climb and the dollar falls.  But we wouldn’t bet the farm on foreign stocks, especially as interest rates rise worldwide.

NOT

Bonds The Federal Reserve’s 16 rate hikes over the past three years have finally had their desired effect.  Since January the rate on 10-year Treasury bonds has climbed to 5.15 percent from 4.40 percent.  That’s bad news for bondholders, since bond prices fall when yields rise.  The total return on the 10- year has been –4.5 percent.

Outlook If you need the fixed income, higher yielding newly issued municipal bonds and Treasurys are not a bad idea, especially for people in higher tax brackets.  But bonds a an asset class, which have averaged a 5.2 percent return since 2000, will be lucky to break even in 2006.

Health Care Biotech stocks are down 9 percent, while HMOs have tumbled almost 20 percent.  A slow moving Food & Drug Administration, along with worries over Medicare and insurance reimbursements, has cast a pall over the sector.

Outlook  The stocks many continue to suffer if Democrats who rail against the high profits of health care firms, take back Congress.  But if you can deal with short-term pain, but large biotech firms such as Gilead or Amgen, which have robust product pipelines and are trading at historically cheap valuations.

Internet Retailers Amazon.com and eBay were two of the four worst performing stocks in the S&P 500, down 29 and 26 percent, respectively.

Outlook  Blame bricks and mortar retailers for finally figuring out how to use the Internet effectively to sell stuff, slowing eBay’s sales growth and forcing Amazon to discount heavily.  The stocks might stay out of favor this year, but loner term, keep in mind that legendary value investor Bill Miller has made eBay and Amazon two of his biggest investments.  We wouldn’t bet against him.

-Russell Pearlman, Smart Money,
July 2006

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