From the January 2004 issue of Investment Advisor • Subscribe!

January 1, 2004

Chugging Along

Our market strategists take the measure of 2004. They like what they see

Wall Street isn't partying like it's 1999 again--not yet, at least. But as the economy and stock market continue to awaken from their post-bubble blowout, a wide majority of the eight sages who make up Investment Advisor's market strategy panel think that the recovery rally of 2003 will sustain itself well into the New Year.

Our fearless forecasters see continued low inflation, modest increases in short-term interest rates, if any at all, and strong GDP growth. On average, they figure the Dow Jones Industrials will finish 2004 at 10,521. While that would mean a slowdown from the 20%-plus gain the Dow and Standard & Poor's 500 both recorded in 2003, it still would represent a decent increase of more than 5%. Excluding perennially bearish advisor A. Gary Shilling's forecast of an 8,000 Dow, in fact, our panel sees the Dow ending the year around 10,881. Argues Gary Thayer of A.G. Edwards & Sons: "We are encouraged by what we are seeing as far as economic growth prospects and earnings trends."

The pundits' 2004 forecast is all the more encouraging in that most of the panel nailed last year's Dow and GDP numbers nicely. As of mid-December it looked as if only two members--Shilling and Anthony Chan of Banc One Investment Advisors--missed the Dow returning to 10,000 for the first time in a year and a half. More panel members found themselves too conservative on high tech, as the Nasdaq roared back 40%, and missed the big decline in the value of the dollar against the euro and Japanese yen. "The fundamentals" of the U.S. economy "have been so exceptional," explains Chan, who adds that most forecasters were surprised to see the Bush Administration allow Treasury Secretary John Snow to suggest he wouldn't mind "a little bit more weakness" in the U.S. currency.

But a weaker dollar could provide the fillip the manufacturing sector needs to continue working its way out of distress. Both Thayer and Lincoln Anderson of LPL Financial, for example favor basic materials stocks in '04 as a way to play this recovery. And a number of panelists believe that technology stocks will show more gains as the year unfolds. Yet Sam Stovall of S&P maintains the broad market is not overvalued. He notes that 2004 estimated price/earnings ratios for the S&P 500 are back to 20 for operating and 23 for reported profits. That, he says, is well within the 15-year average for both and "certainly nowhere near bubble valuations."

One political note: Seven of the eight panel members think the White House will remain in Republican hands come November (only Richard Bernstein of Merrill Lynch abstained).--W.G.

Richard Bernstein

Merrill Lynch & Co.

Richard Bernstein, a quantitative investor and the Thundering Herd's chief U.S. strategist, says he prefers to speak for the entire Merrill Lynch strategy and economics department. For 2004, he--and his Merrill research colleagues--come off as moderate bulls on equities. But he differs with many other pundits in maintaining that the U.S. economy and corporate profits will slow this year. "The economy is later in the cycle than many believe," he cautions, adding that China's furious rush to add manufacturing capacity threatens to cast "a deflationary black cloud" over the world.

Bernstein observes that as 2003 drew to a finish, late-cycle stock groups, such as materials and energy, were already beginning to lead the market. Of the two groups, however, he is more inclined to recommend buying energy stocks. Bernstein reasons that mutual funds are "distinctly" underweighted in both the energy and utility sectors. He further believes that energy stocks in particular are undervalued relative to materials. One possible reason is that many traders have tended to shun the energy sector because of its chronic underinvestment.

Bernstein is also eyeing consumer staples as another typical late-cycle outperformer. But he warns against going into consumer discretionary stocks as well as technology issues, which roared back to life in 2003. "They are overvalued, high-beta sectors in which the fundamentals are far worse than most investors realize," he says.--W.G.

Anthony Chan

Banc One Investment Advisors

Like Richard Bernstein of Merrill Lynch, Anthony Chan, chief economist at Banc One Investment Advisors, thinks U.S. corporate profits will moderate in 2004--perhaps showing an increase of 12%, versus 18% in '03. But he adds that still will leave profits at "impressive" levels at a time when the U.S. economy is in "the earliest stages of expansion." As a result, Chan sees the Dow Jones industrials remaining well above 10,000 through 2004.

A former Federal Reserve economist who remains a dedicated Fed-watcher, Chan thinks the U.S. central bank will raise interest rates by 25 to 50 basis points sometime in the second half as the economy continues to gain steam. That could dim the allure of financial stocks, he thinks. But he sees plenty of opportunities in other areas. "The energy industry," he notes, "doesn't do well in the early stages of a bull market. But as it ages, energy tends to do better."

Chan also favors health care issues for 2004, but thinks the dollar will remain in the dumps, trading at 91 cents against the euro. After years of publicly stating its preference for a strong dollar, he observes, the White House has lately begun to alter its course. Now, he says, the Bush Administration has given every impression that it will tolerate "a little more weakness rhetoric" from Treasury Secretary John Snow--something that would have been strictly forbidden under President Bill Clinton or during George W. Bush's previous years in office.--W.G.

Sam Stovall

Standard & Poor's Corp.

With the broad market rising more than 20% in 2003, Sam Stovall, chief investment strategist for Standard & Poor's Corp., says it's hard to argue that stocks are at "bargain basement" levels anymore. But neither are they especially dear. He figures that 2004 estimated price/earnings ratios for the S&P 500 come in around 20 for operating and 23 for reported profits. That, he says, is well within the 15-year average for both and "certainly nowhere near bubble valuations."

Indeed, Stovall says that if one were to value the stock market on earnings alone, it would not be hard to come up with a year-end reading of more than 1,200 for the S&P 500, a gain of nearly 20% over its late-2003 level. Earnings in the materials sector alone should rise 57% in 2004, he says, with technology not far behind at 51% and health care registering a strong 23% advance. Indeed, high tech remains Stovall's favorite stock sector for '04. By contrast he is dim on utilities, which he expects to eke out an average 4% earnings gain this year. "The sector is dominated by electric companies that, in general, are fairly slow growers," he says.

Stovall says the U.S. economy has plenty of steam left. Tax cuts continue to bolster confidence, he says, and "the consumer will continue to spend." And while the Federal Reserve could push up short-term interest rates slightly in June, Stovall thinks its message will be more a reminder that it remains vigilant against inflation than an aggressive shift to tighten credit.--W.G.

Gail Dudack

SunGard Institutional

Brokerage Inc.

Although she sees stocks rising in 2004, Gail Dudack, chief investment strategist at SunGard Institutional Brokerage Inc., thinks "the market will have a hard time finding much traction." She feels that traders have already discounted a further economic recovery and gains in corporate profits and instead will focus more on the Federal Reserve.

Dudack expects to see increases in both employment and corporate spending, and believes Fed Chairman Alan Greenspan will react by midyear, pushing the Federal Funds rate up by 120 basis points over a six- to eight-month period. Still, that will only take Fed policy from expansionary to neutral--hardly enough to sandbag a recovery on the eve of a presidential election.

In this iffy market scenario, Dudack thinks energy and healthcare-related stocks will stand out. Amid Iraq jitters and strong demand, crude oil prices have been hovering around $31 a barrel. Yet she observes that Wall Street is basing its 200 energy industry profit forecasts on a price of $25 to $28. In addition, large integrated oil firms sport dividend yields of 2.6% to 3.6%, which will help support their share prices. Health care, meanwhile, is "the growth sector of the decade." But rather than focus on big pharmaceutical makers, Dudack favors a number of subsidiaries, including biotech firms, medical device makers, product distributors, and makers of software for the healthcare industry.--W.G.

Lincoln Anderson

LPL Financial

"I think returns on equities and a recovery in the equity markets will stand out" in 2004, offers LPL's optimistic Lincoln Anderson. "It will be a great year."

In 2003, the chief investment officer told IA that the Dow would rise to around 10,500. Fighting us for another month in order to see how 2003 will truly end, he says he thinks "the economy is going up very strongly and corporate profits are rising even more strongly, and I expect both of those trends to continue. I think the market rise will be consistent with further declines in P/Es. I am very realistic on earnings for next year but they are strong forecasts"--he offers 11,500 for the DJIA in 2004.

One area Anderson is very bullish on is tech. "Technology is generating substantial consumer interest and spending," he says. "The links between technology and media are vastly improving every day. We now have wonderful computers with Tivo built into them that interface beautifully with your stereo system and your plasma television. Additionally, advances in wireless high-speed communication technology will help drive consumer technology spending at a good clip next year."

He's also becoming bullish on the beleaguered buck. Although currency traders have been pummeling the dollar lately, Anderson feels strongly that the decline "will peter out and then turn around and go the other way." He adds that "momentum tends to drive currencies past fundamental value, and I think that we are in the midst of one of those momentum-driven moves." So at some point, "we will get a break in that momentum and we will move back in the other direction. I think fundamental [value] on the yen/dollar is around 160. However, we are a way from that." Indeed, as of December 3, the dollar was trading at 109 Japanese yen, a far cry from the 140 Anderson expected. But for 2004 Anderson thinks the buck could move up toward at least 120.--M.L.F.

Mark Balasa

The Alpha Group

Technology had a heck of a comeback in 2003 and should continue to do well in 2004, says the Alpha Group's Mark Balasa. Speaking in the midst of the Christmas season and a notable increase in corporate spending, "it seems like there is some momentum building in that sector." Balasa also is high on industrial stocks as well as materials and consumer discretionary issues. So is he an all-out bull? Not exactly.

Actually, "we have somewhat modest expectations for this year, given how dramatic the last half of 2003 has been," Baslasa says. Like Gary Shilling, he is unsure if corporate spending will be able to support the economy. For the DJIA he is anticipating a year-end close of 10,900; 1,170 for the S&P 500; and 2,100 for the Nasdaq. In 2002, Balasa's predictions for the S&P 500 and the Nasdaq for 2003 were almost dead on, if that is any indication for the year to come. "We don't know how strong and how quickly corporations will keep going up, so much of the good news has already been built into the industry we have now."

With the Federal Reserve widely expected to push interest rates higher sometime this year, Balasa thinks, bonds are unattractive. He is also no fan of utilities. They are "typically interest-rate-sensitive, given their structure and there is going to be a lot of pressure on them." Steer clear of energy and consumer staples stocks as well, Balasa cautions.--M.L.F.

Gary Thayer

A.G. Edwards & Sons

A return to manufacturing is what will surprise people the most in 2004, says Gary Thayer, chief economist at St. Louis-based A.G. Edwards & Sons. "People have written off manufacturing and if we go through a year of inventory rebuilding, then manufacturing will come back a bit. Our economy isn't the only thing that is doing better, the whole world is doing better," he argues. "With the dollar down and manufacturers competitively pricing against foreign manufacturers, there [will be] some recovery in the business. And that could be a pleasant surprise."

Still, Thayer does not see the dollar's weakness enduring. Thayer believes it will strengthen again after the Fed raises rates. "All along we have viewed the decline of the dollar as a reflection of the Fed's reflation policies," he says. "By holding interest rates below the rate of inflation, that traditionally is not good for the dollar."

Thayer thinks that while investors are less risk-averse than they were a couple years ago, they are not yet overpaying for stocks. Bonds, however, may be a tad pricey, given widespread expectations of rising rates. In the bond market last year, "we saw a weakness associated with the [Iraq] war, " he acknowledges. "I think if we hadn't had the war, and the economy had been strengthening all year long and rather than just the two latter quarters, we probably would have seen stronger growth and higher yields by now." In 2004 he expects 10-year U.S. treasury bond yields to hit 5.1%. That's lower than his forecast of 5.4% for 2003, to be sure. But it's still a long way from the 4.2% yield Treasuries were fetching in mid-December. --M.L.F.

A. Gary Shilling,

A. Gary Shilling & Co.

Shilling, an economist and investment advisor in Springfield, New Jersey, carries a well-deserved reputation for being exceptionally bearish. After all, he boldly predicted the Dow would end 2003 at 7,000. With the Dow comfortably above 10,000 as Christmas neared, Shilling acknowledged that "buyers are more aggressive" than he had anticipated. "There has been tremendous expectation of a straight-up economy and indeed the first quarter was very strong. I obviously was wrong at least on the timing."

For 2004, Shilling remains a bear, though moderately less so than he was in '03. The Dow, he thinks, will finish 2004 at 8,000. The big question in Shilling's mind is, "Will business spending on inventories and planned equipment pick up the economic leadership, which has thus far been in consumer spending and housing?"

Shilling concludes that it is unlikely the U.S. will see business spending strong enough to achieve this goal. "If that's the case, we are not going to get the 20% profit growth next year built into stocks already, and that could provide some serious disappointments."

For 2004, Shilling is looking for defensive stocks to come to the fore. These include utilities and other issues that offer good dividend payouts. "There are virtually no stock groups that go up in a bear market, at least consistently over time, but utilities seem to be less hurt than other sectors," he offers. And in this post-Enron world, "dividends suggest the company has real earnings and real cash flow." --M.L.F.

Editorial Director William Glasgall can be reached at bglasgall@ia-mag.com. Staff Editor Megan L. Fowler can be reached at mfowler@ia-mag.com.

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