The New Year Brings an Old Bull
By Stephen Biggar and Robert Gold
Many investors were disappointed by 2004's relatively muted stock market advance. After all, 2003 saw the Standard & Poor's 500-stock index climb 26.4%. 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 stock buyers 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.
We at S&P expect that 2005 will not be a blowout year, either. One reason is the aging of the current bull market. The upward move began after the S&P 500 bottomed out in October, 2002. That puts us well into the third year of this advance. Since 1942, the average advance in a bull market's third year 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 even though bull markets have lasted an average 4.5 years since World War II, there have been three times when a new bear market began even before the third-year bull had come to a close.
We don't expect a new bear market to begin in 2005. We think the year should be moderately profitable for investors in equities. Corporate profits should hit a new record again next year. And we see a 10% earnings gain for the S&P 500. Although that's less than half the spectacular 23% earnings advance that we estimate for 2004, it remains substantial 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 at the end of 2004, more than double the level seen in 1999. We expect 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.
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.
Another possible use: share buybacks. 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. With fewer companies choosing to grant stock-option compensation, owing to likely accounting rule changes requiring the expensing of such options, S&P believes that net share reductions are likely in 2005.
POTENTIAL OIL RISK.
Businesses can also use their cash for capital spending. S&P's economists estimate that 2005 spending on equipment will rise 10.8% year-over-year. Although that doesn't directly affect share prices, the purchase of new equipment should make a company more efficient, which can improve its profitability.
We see the market's valuation as neither expensive nor dear. The S&P 500 is currently trading at a price-to-earnings multiple of 21, based on trailing 12-month "as reported" earnings, which is very close to its 20-year average multiple of 22. In addition, the current multiple is 54% below the 46 p-e seen in 2001.
Potential risks to our market forecast exist. 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 dollar's decline 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's within the realm of possibility.
A falling dollar raises the prices of imported goods and can cause inflation to climb. 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 than we now expect, and that could have a negative effect on share prices. We believe 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 1,300, an 8.3% gain from the 1,200 we project for yearend 2004. Add 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.
Biggar is director of North American equity research and Gold a senior portfolio group analyst for Standard & Poor's Equity Research Services