January 2, 2005

Wall Street's Crystal Ball
Reveals an Overcast 2005

Wall Street has gazed into its crystal ball for 2005 and likes what it sees -- sort of. We spoke with 10 strategists to find out how they think financial markets will perform next year.

While the general consensus is positive for stocks in 2005, the strategists see several clouds lurking. Skyrocketing U.S. budget and trade deficits, tepid job growth and weakening corporate profits are all current trends that could hurt the economy and stocks.

The biggest fear of all, we found, is of inflation. The Federal Reserve raised its target on the federal-funds rate five times in 2004 to 2.25% in order to keep a clamp on inflation. Yields on long-term Treasury bonds, though, ended the year almost exactly where they started -- surprising since bond yields typically rise in sync with inflation to make them more attractive to investors who may be lured equities.

"We've almost had a miracle in the bond market this year," says Phil Roth, chief technical strategist at Miller Tabak in New York, one of the more bearish forecasters we spoke with. Mr. Roth thinks that miracle could turn into a curse for investors if interest rates take off in 2005 as the Fed tries to head off any rapid acceleration in inflation.

Not everybody agrees. Edward Yardeni, chief investment strategist at Oak Associates in Akron, Ohio, says inflation will remain tepid next year due to increasing globalization. "Free trade is another way of saying more competition, and there's more competition with globalization, which offsets inflationary pressures," he says. He predicts the 10-year Treasury yield will remain relatively stable, floating between 4% and 5%.

Another recurring theme: cold, hard cash. Most analysts expect companies to start spending in 2005 at a quicker pace than they have in recent years. Indeed, we've already seen companies unleash some of their horde in a wave of dividend increases, stock buybacks and mergers and acquisitions. The question is whether they also will use that cash to start hiring more workers.

Strategists only issued forecasts for the indicators they cover. Read on for 2005 forecasts, gathered through interviews with each strategist, as well as research reports. They're listed in order of expectations, from bullish to bearish -- though there are few bears out there these days, which may give contrarians pause.

Forecasts for 2005

Oak Associates
Edward Yardeni, chief investment strategist
Akron, Ohio

S&P 500: 1385; DJIA: 11700
Fed-funds rate: 3%
10-year Treasury yield: 4.5%
Dollar: The euro at $1.45 in the first half

"The most critical element of my forecast is my very benign outlook for inflation," writes Mr. Yardeni, who predicts inflation as measured by the consumer price index will hold steady at around 2% -- for the rest of the decade.

That's some forecast; he offers several reasons to back it up. The end of the Cold War and China's admission to the World Trade Organization accelerated globalization, he argues, spurring the integration of national markets around the world. That development acts as a catalyst to free trade, which helps keep down inflation through increased open competition.

In other words, writes Mr. Yardeni: "Prosperity, like love, conquers all."

* * *

Wells Capital Management
James W. Paulsen, chief investment strategist
Minneapolis

S&P 500: 1325
Fed-funds: 4%
10-year yield: 5.5% to 6%

Near the top of many market watchers' lists of danger signs is the relatively weak spending by consumers during the holidays.

While luxury goods flew of the shelves, low-income consumers, crimped by a slack job environment and rising energy prices, have hurt discount retailers such as Wal-Mart, which in November ratcheted down its holiday sales-growth forecast to 1% to 3% growth from 2% to 4%. And with interest rates on the rise, the days of cheap credit could be coming to an end.

Mr. Paulsen, however, thinks consumer spending will continue strong into 2005. "In the last year, wages and salaries have risen by about 5%," he says, while the core personal-consumption-inflation rate has gone up by just 1%. Household net worth in the last year has grown at a 10.2% rate, according to his calculations, primarily because property values have skyrocketed.

One figure Mr. Paulsen expects to focus on in 2005 is the U.S. trade deficit. "The surprise of 2005 is going to be that the trade deficit improves," he says. "That's why I think growth is going to be stronger than people think and that job creation and profits will be stronger than people think."

What does that mean for the market? "Stocks go quite a bit higher," he says.

* * *

Goldman Sachs
Abbey Joseph Cohen, chief investment strategist
New York

S&P 500: 1325; Dow: 11800
Real gross domestic product: 3.4%

Ms. Cohen also sees the spending-weary consumer as a potential red flag heading into 2005. In recent years, "we've been fortunate in that consumers have done what they do best, and that is consume," she says. "But that has to be followed up by businesses being willing to spend."

As businesses start unloading all the extra cash sitting on their balance sheets in 2005, job growth should pick up, says Ms. Cohen. Since "balance sheets are in their best shape in a long time," that will lead to increased M&A activity, more dividends, share buybacks and job expansion.

"Clearly the rate of job expansion has been disappointing, and we're going to be waiting to see what companies do in 2005," she says. "We're hoping that there will be somewhat better job creation in 2005."

* * *

PNC Advisors
Jeff Kleintop, chief investment strategist
Pittsburgh

S&P 500: 1275 to 1325
10-year yield: 5%

Mr. Kleintop points out that while stocks have had a decent run recently, the broader market remains far below the peaks reached in 2000. The Standard & Poor's 500-stock index, he notes, must rise more than 25% to reach its March 24, 2000, high of 1527.

But don't expect the S&P to regain all of that territory next year, he says. Mr. Kleintop expects the broad index to end in between 1275 and 1325, a decent return of about 8% for the year. He recommends investors put 65% of their assets into stocks and 30% into bonds. "We lean toward large-capitalization stocks and have a bias toward the growth style of investing," he says.

One interesting move Mr. Kleintop made at the end of 2004 was a model portfolio shift out of cash -- the remaining 5% of the portfolio -- into international bonds, which he says should benefit from the decline in the dollar.

* * *

A.G. Edwards
Stuart Freeman, chief equity strategist
St. Louis

S&P 500: 1270 to 1300; DJIA: 11600
Real GDP: 3.25% to 3.5%
Fed-funds: 3.5%
10-year yield: 5%

Mr. Freeman expects corporate profits and consumer spending to slow down in 2005 -- and that's not necessarily bad for stocks, he says. If spending and corporate growth get out of hand, he says, investors have to start worrying about inflation and higher interest rates. Such fears held back stocks in 2004, he says.

Moderate consumer spending and declining profit growth, therefore, should be "more favorable for U.S. equities" in 2005, he says, as corporations increase capital spending and add new jobs. As the environment ripens for equities, investors will be drawn toward large-cap stocks and away from small caps, Mr. Freeman says. "We're into a period of about five years of small-cap outperformance, and that's at the longer end of the cycle," he says.

Whither inflation? Mr. Freeman forecasts core inflation of 2.5% for 2005, since the economy isn't "going to get the impact from oil prices that we saw in 2004" and a declining worker productivity, according to government data, should slow growth.

* * *

Standard & Poor's
Sam Stovall, chief investment strategist
New York

S&P 500: 1300; Nasdaq: 2360
Real GDP: 3.6%; CPI: 2.3%
Crude oil: $39 a barrel

The weakening consumer also crops up in the outlook from S&P investment strategist Sam Stovall. The consumer will "support economic growth," but won't lead it, he says, citing an increasingly worrisome "mountain of debt" consumers have built up in recent years.

Much like other strategists, Mr. Stovall expects businesses to start spending the cash that's been piling up. One result will be a sharp increase in equipment investing, which he expects to grow near 11% next year. And that should translate into job growth as companies staff up to meet the new orders.

One of the primary risks to growth next year, he says, is a return of crude oil to $50 a barrel or more and a freefall in the dollar, which could cause a spike in inflation. Mr. Stovall expects the CPI to rise to 2.3% by the end of the year. But when push comes to shove, he says, it's more likely that it will go higher than lower. "All of the major economies in the world are expected to rise in 2005," he says, "And that should put pressure on prices."

* * *

Smith Barney
Tobias Levkovich, chief investment strategist
New York

S&P 500: 1300; DJIA: 11700

"We started getting more positive on the market in September" as a number of conditions continued to improve, says Mr. Levkovich. Principally, he says, companies' huge wads of cash gives them power to "take things into their own hands." The question is whether companies will use that cash to hire.

"We're seeing all the right signals," says Mr. Levkovich. "But there's no guarantee. It won't be phenomenal. Companies have learned to be more productive with fewer workers."

Mr. Levkovich recommends investors put 60% of their funds in equities, 35% in bonds and 5% in cash. He likes farm-related stocks, consumer staples and biotechnology stocks. Technology stocks may turn around some time in 2005, he says, but he's not sure when.

The biggest risk to the economy? Protectionism, he says, which "would cause unhealthy inflation."

* * *

Briefing.com
Dick Green, Chief Executive
Chicago

S&P 500: 1275; DJIA: 11400
Fed-funds: 3.5%
10-year yield: 5%
Gold: $425
Real GDP: 3.5%

"The stock market outlook for 2005 is good," writes Mr. Green. But not great. His S&P forecast is among the lower end of the 10 market watchers we surveyed.

Still, 2005 should be a solid year for profits, he says. Economic growth should "continue at a fast pace" in 2005, enough to produce 10% earnings growth for the year.

The biggest obstacle to a strong 2005 is a sharp rise in interest rates, he cautions, so keep your eye on the 10-year note, which remained quiet throughout 2004 even as the fed-funds rate increased by 1.25%.

"A sharp rise in the 10-year note yield could cause the P/E [price-to-earnings ratio] to contract more than expected if investors see that as likely to curtail the economy and earnings growth into 2006," writes Mr. Green. And that might cause a spike in -- you guessed it -- inflation.

* * *

Bank of America Securities
Thomas McManus, chief investment strategist
New York

S&P 500: 1200

Mr. McManus, one of the few 2005 bears we surveyed, thinks stocks have gotten too pricey relative to earnings. That makes them a risky bet heading into a year that will likely see rising interest rates, he says. Today's stock valuations "overlook the significant rise in inflation expectations," writes Mr. McManus.

Inflation isn't going to creep -- it's going to jump right in our faces, he says, since "we're going to see a plethora of rising prices" in the first several weeks of the year.

Investors have become overconfident, says Mr. McManus, and are ignoring a number of risks. Part of that overconfidence stems from the fact that P/E ratios, while high by some accounts, are still well off their historic highs. The operating P/E ratio of the S&P 500 companies currently is at 21.02, compared with 46.05 in December 2001. But as inflation ramps up, companies will have trouble maintaining their profit margins, he says, and that could hurt P/Es.

* * *

Miller Tabak
Phil Roth, chief technical market analyst
New York

S&P 500: "If you put a gun to my head, I'd say it's down."

Long-term Treasurys have failed to price in the real rate of inflation, says Mr. Roth, due to a prevailing view that the U.S. economy has been soft. "People have constantly distrusted the economic expansion and believed that there was no inflation," he says. "But there are strong signs that inflation is picking up."

He says that "we've almost had a miracle in the bond market this year" and that "bonds are much more mispriced than stocks. That will be the story for 2005." Rising long-term interest rates, he says, could "choke off the market."

Want one more reason to be careful next year? It's the Year of the Rooster, according to the Chinese calendar. And Mr. Roth – a technical strategist on Wall Street -- says Years of the Rooster are usually Years of the Bear as well.

If Mr. Roth is right, a number of the strategists we spoke with may have to eat some crow by the end of 2005.