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A Quick Glance in My Crystal Ball

By Sam Stovall At this time of year, investors are deluged by voluminous dissertations on The Investment Outlook for [fill in the upcoming calendar year]. I don't know about you, but if I open a document and see that it contains more than three or four pages, I either close it and vow to read it later (a vow I frequently break), or I print it out and toss it in my briefcase. I do so with every intention of finding a use for it during my commute home -- as a placemat, for example.

So perhaps the motto for this particular investment outlook should be: Keep it short, Sam. With that in mind, I have compiled a series of macro-to-micro projections made by S&P's economists, strategists and analysts, for the coming year. Let's start with the big picture:

Economic Forecasts

Real U.S.

gross domestic product (GDP) is expected to advance a healthy 3.6% in 2005, on top of the 4.4% rise seen for 2004.

The consumer should support economic growth, but not lead it, since Americans are basically spending all that they earn and continue to shoulder a mountain of household debt. Consumer spending will likely rise 3.1% in 2005, following the 3.7% growth expected for 2004.

Instead, the leadership will come from businesses, spending heavily to respond to new orders, as well as replace aging equipment.

The jobs picture is projected to improve, as businesses add staff to handle the expected increase in orders. Jobs growth is expected to increase to an average 133,600 per month in 2005, vs. the average 131,300 anticipated for 2004. What's more, the unemployment rate is seen falling to an average of 5.2% during 2005, vs. 5.5% in 2004.

A pickup in inflation is not expected to result from this continued improvement in economic growth. We forecast both the overall and core (excluding food and energy) consumer price indexes to rise by 2.3% in 2005.

The Federal Reserve should continue to raise short-term interest rates until establishing a neutral Fed funds rate of 4% just prior to Alan Greenspan's term expiration in January, 2006. The yield on the 10-year Treasury note should edge up to 5%.

The U.S. dollar should continue sliding to $1.45 to the euro and 95 yen per dollar by yearend, 2005.

The twin deficits will remain large. The current account deficit is seen swelling to $738 billion in 2005, from the $662 billion for 2004, while the U.S. budget deficit will likely narrow to $338 billion from this year's $412 billion.

Crude oil prices for the benchmark West Texas Intermediate grade are seen slipping to $39 per barrel by the end of 2005 from the current $45.

Global economic growth rates are all projected to be positive, ranging from 1.8% in Japan and 1.9% in Europe to 3% for Canada and and 3.5% Latin America. Some of the fastest growth is likely to come in non-Japan Asia, with an overall forecast of 6.2% (including a 7% advance projected for China).

Investment Outlooks

We still favor equities over bonds and cash, as interest rates rise and corporate profits hit new highs.

S&P's Investment Policy Committee recommends an asset allocation for a typical balanced investor of 45% U.S. equities, 15% foreign stocks, 25% short-term bonds, and 15% cash.

Our S&P 500 target price for yearend 2005 is 1,300, indicating an anticipated 8% advance over our 1,200 target for 2004. The Nasdaq composite index is seen closing 2005 at 2,360, 9.5% higher than recent levels.

Investment catalysts include a gradual reduction in oil prices, the weakening dollar's effect on foreign revenues and earnings, moderate inflation, a double-digit increase in corporate earnings, and a market price-earning ratio that is two percentage points below its 16-year average. We believe all these factors will be sufficient to counterbalance a 1.75% increase in short-term interest rates during the year.

Earnings for the S&P 500 are expected to advance 10% in 2005, to $74 per share, up from the 23% rise to $64 for 2004. Earnings-per-share growth estimates and current valuations of mid- and small-cap stocks also continue to look attractive. Indeed, 34% of the stocks with our highest investment ranking, 5 STARS (strong buy), are under $5 billion in market value.

As this bull market -- cyclical or otherwise -- is getting on in years, we recommend leaning toward companies with the highest S&P

earnings and dividend quality rankings of A-, A, or A+.

Risks to this modest scenario are many, including a return to oil prices in the $50 to $60 range, contributing to a slowdown in U.S. and foreign economic growth, and a free fall in the value of the U.S. dollar, which would hurt confidence and cause a spike in inflation concerns and yields.

The S&P Europe 350 Index is forecast to rise approximately 9% next year, which is in line with our earnings growth forecast.

Median earnings growth in Asia (excluding Japan) is expected to slow to 11% to 2004, from 15% in 2004.

S&P Asia equity analysts' recommended country weightings are: Overweight Hong Kong and Malaysia; marketweight Australia, Indonesia, Japan, New Zealand, Philippines, Singapore, South Korea, Taiwan, and Thailand; underweight China.

Sector and Stock Recommendations

If 2003 was a great year (the S&P 500 rose 26% and saw only 4 of its 114 industries post declines), 2004 was a good year (the 500 gained 7.4% through Dec. 17, while 80% of the subindustries advanced). We think 2005 will also be a good year, but not a great year.

Sector catalysts for the coming year include rising dividend payouts and increasing M&A activity. Companies in the S&P 500 have approximately $600 billion in cash that can be put to work buying back shares, paying out dividends, reinvesting in their own businesses, or in acquiring others.

Concerns include rising interest expenses and higher commodity costs, and decelerating earnings growth rates.

The Industrial sector carries an overweight recommendation due to the continued improvement we see for the U.S. economy. Signs of life emerging from manufacturing also should aid results.

Consumer staples has an underweight recommendation, due to expected pressure from higher input costs, rising competition, and a weaker retail environment.

Industries with positive investment outlooks, favorable momentum trends, and 5-STARS stock recommendations include:


5-STARS Stocks

Air Freight & Logistics

FedEx (FDX), UPS (UPS)


Amgen (AMGN), Genentech (DNA), ICOS Corp. (ICOS), Invitrogen (IVGN), Protein Design Labs (PDLI)

Consumer Finance

Capital One (COF), MBNA (KRB)

Data Processing

Affiliated Computer Svcs. (ACS), Automatic Data (ADP), Computer Sciences (CSC), Fiserv (FISV)

Diversified Chemicals

Dow Chemical (DOW), FMC (FMC)

Integrated Telecom Services

CenturyTel (CTL), Verizon (VZ)

Managed Health Care

Humana (HUM), PacifiCare (PHS), WellPoint (WLP)



Oil & Gas Drilling

Nabors Industries (NBR)

Oil & Gas Equipment & Services

Hydril (HYDL), Smith International (SII)

Oil & Gas Exploration & Production

Devon Energy (DVN)

Specialty Chemicals

Cytec Industries (CYT)

Systems Software

McAfee (MFE), Microsoft (MSFT)

We have negative outlooks on the following industries, listed along with stocks ranked 1 STARS (strong sell) or 2 STARS (sell) in the group:


1- and 2-STARS Stocks

Aerospace & Defense

Honeywell (HON

; 2 STARS), Lockheed Martin (LMT

; 2 STARS), Nothrop Grumman (NOC

; 2 STARS)

Auto Parts

Delphi (DPH

; 1 STARS), Superior Industries (SUP



GenuineParts (GPC

; 2 STARS)

Diversified Metals & Mining

Massey Energy (MEE

; 2 STARS), Phelps Dodge (PD

; 2 STARS)

Health Care Facilities


; 1 STARS), Health Management (HMA


Industrial Gases

Air Products (APD

; 2 STARS)

Insurance Brokers

Aon (AOC

; 2 STARS), Brown & Brown (BRO

; 2 STARS), Arthur J. Gallagher (AJG

; 2 STARS)

Leisure Facilities

Six Flags (PKS

; 2 STARS)

Photographic Products

Eastman Kodak (EK

; 2 STARS)

Thrifts & Mortgage Finance

Freddie Mac (FRE

; 2 STARS), Fannie Mae (FNM

; 2 STARS), Golden West (GDW

; 2 STARS), Washington Federal (WFSL

; 1 STARS)

Tires & Rubber

Goodyear (GT

; 2 STARS)

STARS and Portfolios

S&P issues investment recommendations on a coverage universe of 1,500 U.S. equities in the large-, mid- and small-cap categories. Approximately 30% carry buy recommendations while 12% have sell rankings. Since inception on Dec. 31, 1986, through Nov. 30, 2004, S&P's 5-STARS recommendations have posted an average annual performance of 16.3%, vs. 9.2% for the S&P 500. All 10 sectors in the S&P Composite 1500 have 5-STARS representatives.

S&P also offers and monitors nearly 20 portfolios of stock selections, consisting of qualitatively and quantitatively derived recommendations.

S&P's Top 10 List, consisting of the 10 most highly favored buy recommendations, posted a year-to-date gain of 17.6% through Dec. 17, vs. a 7.4% advance for the S&P 500 (not including dividends).

And finally, the Industry Momentum Portfolio (featured each week in the Sector Watch column), which selects industries on trailing 12-month relative price performance, is poised to outperform the S&P 500 for the sixth year in a row. Year to date through Dec. 17, the portfolio was up 14.2%.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), their proxies (the highest STARS-ranked companies in the subindustry index -- tie goes to the largest market value) as of Dec. 17, 2004.

Industry Company Ticker STARS Recent Price

Agricultural Products Archer-Daniels-Midland ADM 3 $22

Commodity Chemicals Lyondell Chemical LYO 3 $28

Consumer Electronics Harman International HAR 3 $126

Fertilizers & Agricultural Chemicals Scott's Co. SMG 4 $73

Hotels, Resorts & Cruise Lines Carnival Corp. CCL 4 $56

Internet Retail Ebay EBAY 3 $115

Internet Software & Services Yahoo! YHOO 4 $37

Managed Health Care PacifiCare Health PHS 5 $55

Multi-Sector Holdings Leucadia National LUK NR $70

Oil & Gas Refining Valero VLO 4 $45

Steel Nucor NUE 3 $53

Wireless Telecommunication Services Nextel Partners NXTP 4 $19

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of September 30, 2004, SPIAS and their U.S. research analysts have recommended 29.2% of issuers with buy recommendations, 58.5% with hold recommendations and 12.3% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.


This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's

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