By Joseph Lisanti
Investors are probably a bit happier than they were a year ago. Then, the S&P 500 was on the verge of completing three consecutive down years, something that hadn't happened since the 1939-41 period.
The bull market that began after the index hit a low of 776.76 on October 9, 2002 was a welcome relief from the worst bear market (down 49%) since the Great Depression. On the first anniversary of the new bull, the "500" was up 35% vs. a gain of 36% for comparable periods since the end of World War II. In its second year, a bull usually slows down. Only once in the postwar era has the second year of a market advance been stronger than the first. On average, the S&P 500 has gained about 13% as a bull market moved from its first anniversary to its second.
Other factors also point to potential gains in 2004. As we shift to the fourth year of the U.S. presidential cycle, history shows that stocks do somewhat less well than in the third year. Even so, since the end of World War II, they have posted an average gain of almost 9% in a president's fourth year in office. That's second only to the more than 17% gain typical of third years over the same time span. What's more, almost 80% of the time, the fourth year of a president's term is positive for stocks.
Although there is no way to prove it, we assume that the third year is best for stocks because the economic pump is well primed by the incumbent in an effort to get re-elected. Some of the effects of the pump priming usually carry over into the fourth year.
That would appear to be the case in 2004, as the benefits of the most recent tax cuts continue to be felt. Notably, the new 15% tax on most dividends won't really hit home until investors file their returns in April.
Overall, the tax cuts and the consequences of the Federal Reserve's rate-cutting marathon, which began in January 2001, are likely to keep the economy humming along in 2004. We see GDP growth of 4.7% for the year, with continued subdued inflation. That should lead to strong corporate profits and, therefore, aid stock prices.
On the profits front, Standard & Poor's analysts expect operating earnings on the "500" to climb 14% in 2004. And we think the quality of those earnings will improve.
The narrowing gap between Standard & Poor's Core Earnings, a more stringent measure that takes into account pension and option costs, and operating earnings, points to better-quality profits for U.S. corporations. In 2002, Core Earnings represented only 51% of operating profits. In 2004, we estimate 72%.
The lack of attractive alternatives also suggests to us that stocks should have another positive year. Bond yields are low and likely to rise somewhat as the economy strengthens. And rising yields would produce losses in existing fixed-income holdings. Money market instruments currently have yields below the inflation rate.
Our forecast is for the S&P 500 to reach 1160 by midyear 2004 and 1190 by the end of the year, about an 11% gain from its recent 1074 level. The estimated gain is slightly below the historical norm for the second year of a bull market and above the traditional presidential cycle fourth-year gain.
We recommend an asset allocation of 65% stocks, 10% bonds (short term, unless you plan to hold to maturity) and 25% cash.
Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook