Last Year, Stocks And Profits Were Off the Charts

By Kathleen Day
Washington Post Staff Writer
Sunday, January 7, 2007

Consumer purchases of jewelry, cable TV service, movie tickets, clothing, electronic gadgets, restaurant food and a long list of other discretionary items helped fuel a stellar securities market in 2006.

That buying, born of an optimism fed in part by lower-than-expected oil prices, pumped company earnings to unexpected -- and record -- levels, as did stable interest rates, plentiful supplies of money to borrow and invest, and corporate America's general success in keeping costs down, stock market analysts say.

And it all happened during a lousy housing market.

"Consumers continued to spend. The 'me generation' came back," said Howard Silverblatt, Standard & Poor's senior analyst of the company's widely watched 500-stock index, a broad measure of large, publicly traded companies. "The attitude seemed to be: Never save for tomorrow what you can spend today."

The S&P 500 ended 2006 up 13.62 percent from the previous year, with 11.96 percentage points gained since mid-August alone. That's when company earnings and consumer spending began to outpace expectations, he said, and inflation anxieties eased as interest rates stabilized and oil prices fell from their high in July. It was the fourth consecutive year of gains in the index, a welcome turnaround after technology stocks collapsed in 2000, producing three years of double-digit declines.

But the character of the 2006 gains is unusual: The S&P 500 rose in all but one month, a performance not seen since 1958. "And this is not like at the end of the 1990s, when gains came mostly from technology stocks," Silverblatt said. "This time it's broad. That's important because if one sector falls down, there's others to support it."

Other stock market measures told a similar tale. The Nasdaq composite index, also a broad market measure but slightly more weighted toward technology companies, gained 9.5 percent in 2006. The Dow Jones industrial average, which measures the 30 bluest of the blue-chip stocks, climbed more than 16 percent for the year after spending the fourth quarter hitting one all-time high after another. The Russell 2000 index, which measures the performance of smaller companies, gained 17 percent.

"There was a lot of pessimism going into the year," said Stuart T. Freeman, chief equity strategist for brokerage and investment banking firm A.G. Edwards. "People were pleasantly surprised."

But last year's grand performance increases the chances that growth in 2007 will slow, analysts say.

First of all, investors are likely to engage in profit-taking in the next few months, selling shares to convert paper gains into cash. That could push prices down in the short run, analysts say. More fundamental will be a likely slowdown in consumer spending; Silverblatt estimates it will gain 2.7 percent in 2007, down from a 3.1 percent increase in 2006. (While 3.1 percent might seem low, he said, it was much better than the pickup of 2 percent or less that had been predicted.)

Not surprisingly, that means corporate profits are also predicted to drop. The double-digit gains in earnings that have persisted each year since 2002 are likely to subside into single numbers, said economist Randell F. Moore, editor of Blue Chip Economic Indicators. The latest estimates say that earnings gains for 2006 might reach nearly 20 percent but that they'll probably drop to 5 percent this year, he said.

Last year was also a banner one for mergers and acquisitions, as pending and completed deals globally reached a record $4.06 trillion, an increase of 36 percent from 2005, according to Dealogic, an investment banking analysis firm. One of the year's biggest transactions was AT&T's $85 billion purchase of BellSouth. It pushed AT&T onto the list of the top-10 performing stocks in the Dow average and BellSouth onto the top-10 list of gainers in the S&P 500.

Purchases by private-equity firms -- the new name for leveraged-buyout companies -- reached $737.4 billion, double the previous record set in 2005, and included the two largest ever: Blackstone's $36 billion purchase of real estate company Equity Office Properties Trust and the $32.7 billion buyout of hospital giant HCA by a group including Bain Capital, Kohlberg Kravis Roberts and Merrill Lynch Global Private Equity.

Analysts say these deals help pump up overall stock prices by freeing cash that investors can put back into the market and by sparking speculation about which companies might be likely acquisition targets.

Though consumers shopped and shopped some more, giving top gains to companies such as Harley-Davidson, Big Lots, McDonald's and Walt Disney, they also were more picky. They scooped up flat-panel TVs after Wal-Mart lowered prices, forcing competitors such as Circuit City to follow, while leaving higher-profit items behind.

Even as consumers insisted on steep discounts on electronics, they were willing to splurge on other luxury goods. Tiffany, for example, reported that its biggest increase in sales was for jewelry with a price tag of $20,000 or more.

Strong sales, however, were not the sole factor determining how some companies fared. General Motors, for example, was the Dow's top performer even in the face of declining U.S. sales, a sign investors are gaining confidence in its restructuring efforts.

Wal-Mart and Whole Foods Market, on the other hand, were among the worst performers, as investors questioned their ability to grow as quickly as in the past. So were a trio of technology companies: computer chipmaker Intel and Internet giants eBay and Yahoo.

Information technology was one of only two of the S&P 500's 10 industry sectors to miss double-digit gains for the year. Analysts say there's a debate among investors over whether big technology companies are underpriced or whether those prices signal that their days of gangbuster growth are over.

The other slow-growing S&P sector was health care, hurt by fourth-quarter declines in several areas, including pharmaceuticals. Drug companies have been bedeviled by a lack of new blockbuster medicines, and analysts expect the industry's fate will be affected greatly by the Democrats' new congressional majorities.

The change of political power, however, could cut two ways for drugmakers: Democrats are more likely to cast a suspicious eye on steep increases in prescription drug prices, but they are also more likely to make such drugs widely available to those in need.

Another sector in for greater scrutiny is energy. Democratic leaders are putting together legislation that would rescind billions in drilling incentives and raise federal royalty payments on offshore oil production. The oil industry could face sharp criticism and pricing restraints if fourth-quarter results, due out by the end of the month, show profits at the familiar stratospheric levels of recent quarters.

Political tensions around the globe will continue to hover over the markets, influencing investor confidence, particularly about oil prices. "We are an international economy, and problems travel fast coming in and going out," Silverblatt said.