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|  | DECEMBER 10, 2004
 THE OUTLOOK By Joseph Lisanti A Higher Market Appears Likely in 2005 Despite the risks, stocks look poised to post modest gains in the new year Many investors have been disappointed by 2004's relatively modest stock market gains. After all, 2003 saw a 26.4% advance in the S&P 500, the 12th-best annual showing over the past three-quarters of a century. And 2003's above-average gain came on the heels of the worst bear market in a generation - a 49% decline in the "500" over 31 months. More than a few buyers of stocks hoped that the market would provide at least two consecutive years of outsized advances to make up for the losses suffered from 2000 through 2002. Unfortunately, the market isn't obligated to comply with our wishes. Between 1929 and 1994, a 20%-or-better annual gain in stocks was followed by an advance of similar magnitude only twice (in 1936 and in 1954). That makes the four consecutive years of such gains from 1995 through 1998 (and 1999's close-to-the-mark 19.5% rise) extraordinary, to say the least. The stock market bubble of the late 1990s may well have been a once-in-a-lifetime event. What's more, the ugly bear market that followed may presage a period of below-average gains for stocks. The Depression-era decade of the 1930s saw an average annual total return of only 5.3% for the S&P 500. While the 1940s were a time of respectable 10.3% annual returns, in the 1950s, investors experienced superior results, averaging 20.8% a year. The two subsequent decades saw below-par annual returns (8.7% and 7.5%, respectively). Then, the pattern reversed again in the 1980s (18.2% annually) and 1990s (19%). From 2000 through November 2004, the annualized total return of the "500" has again slipped, and now stands at -3%. We expect that 2005 will not be a blow-out year. One reason is the aging of the current bull market. This upward move began when the S&P 500 bottomed out at 776.76 in October, 2002. That puts us well into the third year of this advance. Since 1942, the average advance in the third year of a bull market has been only 3%. What's more, of the 10 previous bull markets that celebrated a second anniversary, six were either flat or down by the end of what would have been their third year. And, keep in mind that we are in a cyclical bull market. Many market observers believe that it would become a secular (long-term) bull only if prices surpass the old high. For the S&P 500, that would mean a close above the March, 2000 record of 1527.46. We don't expect that to happen in 2005. Nevertheless, we think the year should be moderately profitable for investors in equities. Corporate profits should hit a new record again next year. We see an earnings gain for the S&P 500 of 10.5%. Although that is less than half the spectacular 22.5% earnings advance that we estimate for 2004, it remains substantial, in our view, and constitutes a positive background for equities. The good profits posted in the current economic expansion have left corporate America with a bundle of available cash. The balance sheets of S&P 500 companies contained close to $600 billion in cash and equivalents with less than a month to go in 2004. That compares with $499 billion at the end of 2003 and a mere $260 billion at yearend 1999. We expect that at least some of this cash will be put to work in the coming year. One potential use of the funds is for mergers and acquisitions. Recent major mergers in health care, financial services, media, and telecom services suggest to us that cash-rich corporations will continue to fill in their business portfolios in 2005. That could help boost stocks as speculators scoop up shares of potential targets. Dividend increases are another use for that cash. With taxes on qualified payments to shareholders at a low 15% maximum, we see more companies raising their payouts. That move could improve the market's long-term total return. Share buybacks are another possible use for excess corporate cash. As long as they don't simply offset shares issued in connection with the exercise of options, buybacks often improve per-share earnings by reducing shares outstanding. That can cause investors to bid up the company's shares. Companies can also use their cash for capital spending. Standard & Poor's economists estimate that spending on equipment will rise 10.8%, year over year, in 2005. Although that doesn't directly affect share prices, the purchase of new equipment should make a company more efficient, which can improve its profitability. While corporate profits and cash positions are a plus, some investors are worried about the market's current valuation. Based on 12-month trailing "as reported" earnings, the S&P 500 is trading at a price-to-earnings multiple more than 30% above the 70-year average p-e of 16. Although it is difficult to make a case that stocks are cheap, it is equally hard to argue that they are dear. The "500" recently traded at a multiple of 21, very close to its 20-year average p-e of 22. And the current multiple is 54% below the 46 p-e seen in 2001. Overall, given our expectation of decent earnings growth in 2005, we don't see the market's current valuation as an impediment. There are, of course, potential risks to our market forecast. Primary among these is the price of oil. Although we expect oil to decline to $40 a barrel next year and to $35 in 2006, Middle East conflicts, Nigerian labor unrest, or another dispute between the Russian government and a local oil company could send prices higher again. Oil imports make up a good part of the U.S. current account deficit. Imports of goods are another large part. The decline in the dollar is the market's way of adjusting for the imbalance. We see the dollar continuing to decline. While we don't share the fear of a dollar freefall, it is within the realm of possibility. A falling dollar raises the prices of imported goods and can cause inflation to rise. We see a modest increase in consumer prices, on the order of 2.3%, in 2005. But if inflation turns sharply higher, the Federal Reserve might have to raise short-term interest rates more rapidly, and that could have a negative effect on share prices. We expect the Fed to be able to raise rates gradually, with relatively minor consequences for stocks. Overall, we see the S&P 500 ending 2005 at 1300, an 8.3% gain from the 1200 we project for yearend 2004. Add in a 1.7% dividend yield, and our projected total return is just slightly below the 11.2% annual average posted by the "500" since the end of 1969. In this environment, we suggest 45% in domestic equities, 15% in foreign stocks, 25% in short-to-intermediate-term bonds, and 15% in cash.  Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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