History Smiles on 2005

Under similar conditions in the past, the S&P 500 index has posted moderate gains

By Joseph Lisanti

The drubbing that stocks took in the first few days of trading this year was not what most investors were looking for in 2005. Two years of gains, albeit including a more modest one in 2004, made some people believe the strong rally that began in early November would continue unabated.

An often-cited reason for the early January decline was the release of minutes of the Federal Reserve Board's Open Market Committee meeting of December 14. The minutes indicate that the Fed believes the current 2.25% fed funds rate (the rate that member banks charge each other for overnight loans) remains "below the level it most likely would need to reach to keep inflation stable."

This should not have been a surprise to anyone, since the Fed has been signaling for some time now that it intends to effect a slow and steady increase in short-term rates. David Wyss, Standard & Poor's chief economist, believes that fed funds will reach 4% by the end of this year. We suspect that the release of the minutes was an excuse for some traders to take profits.

With rates climbing and corporate profit growth slowing, we believe that 2005 will not be a great year for stocks, but it should be a good year. History appears to confirm our belief. Over the past three-quarters of a century, the S&P 500 has seen two successive years of gains following a down period a dozen times. In the 11 instances before the 2003-2004 advance, the market rose an average of 6.1% in the subsequent year. Eight of the 11 times, the index was up in the third year.

Our S&P 500 target for yearend 2005 is 1300, which would be a gain of 7.3% from the 2004 close of 1211.92. Add in the index's 1.7% yield, and you have what we consider a respectable 9% return.

For the market conditions we foresee, we suggest 45% in domestic equities and 15% in foreign stocks.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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