Stocks: Five Forces for a Fine Year

Most forecasters predict single-digit returns in 2005, but here are some factors that could make the market blow past expectations

By Amey Stone

The consensus is clear. In survey after survey (including BusinessWeek's own, "What the Fearless Forecasters See," 12/27/04), Wall Street believes 2005 will be a year of single-digit stock market returns.

The economy will hum along at 3% to 4% growth, inflation will remain moderate, and interest rates low, the conventional wisdom holds. But corporate earnings will slow, so stocks, which have already enjoyed some heady gains in the last few weeks, will advance at a slower pace as valuations get stretched.


  It's a very safe and sober prediction. But it ignores a lot of positive momentum investors are seeing right now. "I'm increasingly intrigued by the possibility that 2005 could be a better year than I or most people expect," says Liz Ann Sonders, chief investment strategist at Charles Schwab (SCH ).

Her formal prediction is already quite bullish: That the Dow Jones industrial average will end 2005 at 11,800, a 9% gain from its current level. But she notes: "I see a lot more optimism on the part of Corporate America. Clearly the election was holding them back. Psychology is still in the process of turning here."

In the spirit of New Year's Eve -- and throwing caution to the wind -- I've identified five forces that could propel the market higher than expected next year. All are distinct possibilities, and any one of them would represent a pleasant surprise for investors in 2005:

Happy New Year! Companies open their wallets big-time. Investors have already enjoyed a new round of megamergers like Sprint (FON ) and Nextel (NXTL ), Kmart (KMRT ) and Sears (S ), and Oracle (ORCL ) and PeopleSoft (PSFT ). Such deals are signs that corporate leaders are increasingly willing to spend some of the billions in cash sitting on their balance sheets and invest in future growth.

For the economy to really boom, companies need to spend even more of their dough -- on capital equipment and on their workforces. True, excluding a strong October, payroll growth has been surprisingly weak for this stage in the economic cycle. But that could be changing. Hourly earnings are on the rise in December at the same time as initial jobless claims have dipped. Another positive sign: A surge in consumer confidence reported on Dec. 28.

A strong labor market is what gives consumers the spending power to keep the economy humming. "Our current bias would be for a better-than-expected market in 2005," wrote strategists from SunGard Institutional Brokerage in a Dec. 16 report. That's "fundamentally justifiable as long as employment continues to grow."

Earnings could surprise everyone. In 2004, corporate profits grew nearly 20% year-over-year. In the fourth quarter alone, they climbed 15%, on top of a 28% gain in 2003 (which was the highest quarterly growth in the past 10 years, according to Thomson Financial).

Given such a torrid pace, it's no wonder that most money pros expect earnings expansion to slow next year. According to Thomson, market strategists think profits will grow just 6.1% in 2005. A consensus of analysts' estimates calls for earnings increases of 10.5%.

But think about it. Profits could easily come in stronger than expected, argues Michael Farr, president of investment firm Farr, Miller & Washington. Iraq could stabilize, the price of oil could fall, and earnings could jump. "There are any number of chain reactions that could take place that are very much interwoven," he says. Also helping out: The dollar is expected to weaken further against the euro and the yen, which should make U.S. goods more competitive in global markets.

If corporations and consumers spend more than expected, another year of double-digit earnings gains doesn't seem out of the realm of possibility.

Deficits could get a lot less scary. One of the biggest market fears in 2004 was the rampaging two-headed monster of twin deficits. Not only has federal spending far outstripped revenues, but the U.S. as a whole is spending a lot more than it's producing, creating a mammoth current-account deficit.

In 2005, both those worries could abate, believes Sonders. She thinks the Bush Administration is focused on reigning in nondefense federal spending. Meantime, tax receipts could come in better than expected as the economy improves.

Interest rates could stay low. This would seem a wildly optimistic prediction -- if it hadn't already been the case for so long. For more than a year now, most strategists have expected interest rates to rise. Yet in 2004, even as the Federal Reserve hiked short-term overnight lending rates from 1% to 2.25%, long-term rates barely budged. At the end of December, a 30-year fixed mortgage was still just 5.7%. That's only about a half percentage point higher than the record lows of mid-2003.

The Fed is likely to keep raising short-term rates, but as the past year has shown, that doesn't mean long-term rates will follow suit. With their continued low levels, consumers can actually afford to pay back all the credit-card and mortgage debt they've taken on. Some may even take out more -- not necessarily good for them, but good for the overall economy. Plus, businesses would be able to borrow to fund future growth.

Even better: Low rates make stock prices seem more attractive. The only way equities could look cheap in 2005 is if interest rates stay low while earnings growth comes in faster than expected, says Patricia Van Kampen, chief equity officer at Mason Street Advisors. "That's a big stretch," she argues. But since so many strategists have factored a rising-rate scenario into their market forecasts, it also points the way to further share gains in 2005.

Oil prices could fall. It was only last October that crude peaked at $55 a barrel. Many analysts thought $60 oil was in the offing. Now prices are back down at the $44 level -- and could fall lower if geopolitical tensions abate. "I hope to see oil come under $40 a barrel in '05," says Farr.

That's a tall order, especially as the potential for supply disruptions from the Middle East remains high. On Dec. 29 bombings in Saudi Arabia led to a $2 spike in crude prices that day. Iraq's upcoming elections will likely fuel more terrorism in the region. However, the market has already factored in the likelihood that oil prices will remain high through 2005. If oil prices fall, it would give corporate earnings a boost and help keep budding inflation in check.

What could go wrong? A jump in consumer prices is one of the biggest risks to a better-than-expected bull run in 2005. But as Sonders points out, inflation worries -- like fears of more terrorist attacks or a spike in interest rates -- have been haunting investors for a while now. All the market needs to outperform is for some of the bleakest predictions not to happen, says Farr.

"Not all the calls for rain are met with rain," he says. "Some sunshine does show up." That makes for a fitting New Year's toast for investors hoping for a sunny 2005.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

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