The Easy Money Is Gone, But Next Year Could Still Pay Off If You're Picky

It was a knock-your-socks-off year in the stock market for Mark Ciborowski, 47, head of a real estate management firm in Concord, N.H. He racked up nearly 125% gains by buying mostly small, beaten-down stocks, riding them up steadily as a ski-lift, then jumping out with a tidy profit.

Most investors didn't make such nosebleed returns in 2003, but it's doubtful you'll hear complaints. After three years of the most grisly bear market since the Great Depression, many investors are thrilled to see double-digit gains in their 401(k) and brokerage accounts. Through Dec. 16, the Standard & Poor's 500-stock index was up 22%, the Nasdaq Composite Index popped 44%, and the Dow Jones industrial average -- which recently topped the 10,000 mark -- had risen 21%. In fact, if you weren't in stocks, you're probably feeling like a geek hiding by the punch bowl at the high school prom. Money-market accounts have averaged well under 2% this year, barely keeping up with inflation.

The party's not over, but it may be thinning out a bit. Many strategists think stocks could reap low double-digit gains in 2004, but a repeat of 2003 is highly unlikely. Because stocks have rallied so strongly, many aren't cheap anymore. Besides, interest rates will likely start rising in 2004. Then there are tougher earnings comparisons and a chronically weak dollar, and despite the recent capture of a bedraggled-looking Saddam Hussein, the occupation in Iraq continues. All these factors make Ciborowski merely "cautiously optimistic" about 2004: "The easy money has been made." Still, a 10% gain for 2004 would not be bad at all; in fact, over the past 50 years, that has been the market's average annual return. To best that, investors need to saddle up with stocks poised to benefit from economic recovery.

It's likely that investors' love affair with bonds has gone the way of most courtships spawned on reality-TV shows like Joe Millionaire. If rates rise by as little as 1%, the price of a 10-year Treasury will plunge about 8%. And if you hope the price of your house will continue to outpace the stock market, think again. Rising rates could huff and puff and blow your house value down...or at least sideways.

The good news is there's no question that the economy is building muscle. In the third quarter, gross domestic product grew 8.2% -- the fastest spurt since 1984. A stronger economy will translate into healthy corporate earnings. Analysts estimate that fourth- and first-quarter earnings will come in at about 22% and 13% higher than the same periods a year earlier, according to earnings researcher Thomson First Call (TOC ). For 2004, analysts expect earnings to rise about 12%.

Companies are increasingly flush with cash, and that's likely to fuel earnings. Both operating and free cash flow for the S&P 500 are at their highest in five years, according to, an equities-research firm. Because earnings tend to lag behind cash flow by about six months, StockDiagnostic's research director, Michael Markowski, thinks stocks will be strong at least through the first half of 2004. "When cash flow starts going up like this, it's telling you that companies have plenty of money to pay down debts and are preparing to make capital expenditures," he says.

Market rotation

Although interest rates will likely inch up in 2004, they'll remain very low. John A. Caldwell, portfolio strategies director at McDonald Investments Inc., a division of KeyCorp (KEY ) in Cleveland, says rates have some elbow room. The Federal Reserve focuses on the federal funds rate, at which banks lend to each other overnight, and that is still just 1%, or below the current 1.8% inflation rate. Even so, rates won't rise overnight. Says Caldwell: "The Fed will probably wait until we see more than two consecutive quarters of strong GDP growth and job growth."

Election years, along with the year before them, are usually bullish. According to the Stock Trader's Almanac, the last two years of the 43 Administrations since 1832, including 2003, produced cumulative market gains of 739%, compared with a 228% gain in those Administrations' first two years; average annual gains were 17% vs. 5%. Incumbents tend to pile on economic stimulus in order to spruce up their last two years in office, having applied the bitter medicine, such as tax hikes, earlier. President George W. Bush's 2003 tax cuts, which slashed taxes on dividends and capital gains, provided a booster shot for the market. The effect will likely spill over into 2004. Says Woody Dorsey, a strategist and president of Market Semiotics, a research firm in Castleton, Vt.: "The liquidity boom probably has some tailwind that could take us through the first quarter."

Despite the widening mutual-funds scandal, investors are looking on the sunny side. Our annual BusinessWeek/Harris Poll found that 54% of households think stocks will rise in 2004. That's a big jump from the 41% who thought so a year ago. Mutual-fund flows have held up surprisingly well. Through mid-December, investors poured about $48 billion into equity funds; in 2002 during the same period, they yanked out about $28 billion, according to U.S. Bancorp Piper Jaffray (USB ).

Still, some factors could be a drag on stocks. Beyond unpredictable geopolitical crises or acts of terrorism, the main roadblock in 2004 will likely be valuations. After 2003's run, the median S&P 500 stock is trading at a price-earnings ratio of about 18, based on analysts' estimates of earnings over the next 12 months. That's not exactly cheap, even with rock-bottom interest rates; over the past 50 years, the average p-e for the S&P 500 has been about 15. "The market is fairly to fully valued," says Vincent D. Farrell Jr., chairman of Victory Capital Management. "That means you really have to pick stocks."

For 2004, you'll want to look beyond the many technology equities and small- and micro-cap stocks with lower quality earnings that have been hands-down winners this year. According to a study by Richard Bernstein, chief U.S. and quantitative strategist at Merrill Lynch & Co (MER )., shares of lower-quality companies that lost money over the past decade were up 33% for the year through Nov. 25, beating the 22% gain of top-rated companies whose earnings rose. The catch is that many of these stocks are now overpriced. That's why many experts now favor large caps with solid earnings that have been trading at a discount to the market. Consider energy stocks. "Energy earnings have been phenomenal, but [the group's] performance is the second-worst among 10 sectors," says Bernstein.

Among large caps, companies that have been increasing their dividends, such as General Electric (GE ) and Pfizer (PFE ), could be a good bet. According to S&P, 418 listed companies raised their dividends in the third quarter -- a 40% jump from a year ago. It estimates that dividends for the S&P 500 will rise 10.1% in 2004, compared with an average of just 0.8% over the five years through 2002. Says Philip S. Dow, director of equity strategy at RBC Dain Rauscher Inc. in Minneapolis: "The big story in 2004 will be dividend increases."

Tech stocks that aren't overheated could shine, particularly those of companies that can ramp up production without having to invest more. Some financial companies are still fairly priced relative to their peers, and as takeover deals heat up and investors come back to the market, they could rally. Both high-end and discount retailers look poised for gains. Insurers and pharmaceuticals will likely benefit from recent Medicare reform. High energy prices, coupled with a looming natural-gas shortage, could spark a rally in energy stocks.

Beyond stocks, commodities like nickel and copper should remain durable in 2004. Gold could continue to glitter. Even art could be a portfolio masterpiece.

The bottom line for 2004: To beat the market, you'll need to invest in the best-performing stocks that are trading at low valuations. No, it's not easy. But in this issue we've done some of the spadework for you.

By Marcia Vickers

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