The markets bounced back nicely in 2003 - and experts say signs point to more good times in the new year.
By HELEN HUNTLEY
Published January 4, 2004
After three dismal years, investors finally had something to celebrate in 2003. The question is whether last year's market momentum can carry over into 2004.
"Investors are still holding their breath, hoping this is the real thing and not just a flash in the pan," said Clearwater financial planner Ray Ferrara of ProVise Management Group.
Stocks remain below the peaks of four years ago, but they made up a lot of lost ground last year. The Dow Jones Industrial Average rose 25 percent and the broader Standard & Poor's 500 Index gained 26 percent. The Nasdaq Composite Index went on a tear, climbing 50 percent as investors rushed back into technology stocks.
The size of the comeback has prompted some market watchers to declare that the easy money already has been made in this rally. However, there are reasons to be optimistic that stocks will have another good year, if not a great one.
Reason No. 1: The recovering economy.
"The environment is just right," said St. Petersburg financial planner Robert Doyle of Spoor Doyle & Associates. "We have low interest rates and low inflation. And we have a very growth-oriented administration and Federal Reserve."
Economic growth exploded during the third quarter, to an annualized rate of 8.2 percent. Although there are signs that growth slowed in the fourth quarter, the economy remains much improved over a year ago. Unemployment claims have begun to fall and consumer confidence is much higher than it was last spring even with a dip in November.
"The economy is humming on all cylinders," said St. Petersburg money manager Timothy McIntosh of Strategic Investment Partners. "The tax cut that we had, and the fact that the Federal Reserve Board left interest rates low, accelerated growth in the economy, which I expect to continue. Generally these cycles run a few years at a time, so my expectation is for a three-year upside from here."
He compared the current economy to the golden years of the late 1990s "before the magic wore off."
Doyle said we haven't yet seen all the benefits from the tax cut.
"When people find out their tax refund will be bigger and estimated tax payments going forward will be lower, that will be an unexpected boost to the economy," he said.
As the economy improves, businesses start investing more in technology, equipment and inventories, which keeps the growth cycle going. Expectations for improving corporate profits are a big part of the reason stock prices have gone up.
Ultimately there are two catalysts for rising or falling stock prices - changes in earnings per share and changes in how much investors are willing to pay for each dollar of earnings. Across the stock market as a whole, earnings tend to rise along with the economy. But the second part of the equation is far less predictable. That's where market psychology comes in.
And that brings us to Reason No. 2: With the economy and the stock market showing strength, investors are feeling confident about the future. In December, the UBS Index of Investor Optimism hit its highest level in 21 months. Two-thirds of the investors who responded said this is a good time to invest and three-fourths said they think the stock market will do better in 2004 than it did in 2003. But they aren't euphoric. On average, they expect their portfolios to earn about 10 percent.
The bear market has played a big role in tempering investor expectations. The Securities Industry Association said its surveys show investor expectations dwindled from a 33 percent return in 2000, the year the bull market peaked, to a 10 percent return in 2003.
Reason No. 3 that stocks could do well this year is that fixed-income investments don't offer much competition because of historically low interest rates.
Investors who choose the safety of CDs and money market accounts pay for it dearly with slim returns. By opting for longer-term bonds, they can earn a little more interest, but they increase their risk substantially. If rates rise, bond prices will fall, and investors in long-term bonds will lose the most principal.
Because rates are so low and the economy is strengthening, the rate trend is more likely to be up than down, but predicting interest rates isn't any easier than predicting stock prices. The Federal Reserve manages short-term rates, pushing them lower to stimulate the economy or higher to dampen the effects of inflation. Long-term rates are determined by the bond market, which is where supply, demand and investor expectations about the future come into play.
Many financial advisers are recommending caution, which for them means keeping bond maturities on the short side, generally less than five years.
"Bond investors are not in for a pleasant ride," said financial planner Ferrara.
History is the fourth major reason stocks could have a good year. Presidential election years are usually good for the market. Prudential Equity Group tracked 29 election years back to 1888. Stocks rose in 20 of those years, with an average increase of 17.4 percent.
In election years since World War II, stocks rose 80 percent of the time, with an average gain of 9 percent, according to Standard & Poor's.
The underlying reason is that presidents who want to get re-elected, or who want their political party to maintain control of the White House, are inclined to stimulate the economy. Last year's tax cuts are an example.
Of course, a higher stock market is no slam dunk. There are potential threats out there. Investors will continue to watch nervously every time the Fed meets. Some will worry that the Fed will raise rates and hurt the economy, while others fret over whether the Fed will raise rates enough to keep inflation in check.
A sharp rise in interest rates would threaten stock prices. That's because higher borrowing costs would hurt corporate profits and higher-yielding bonds would present more competition for investor dollars.
The U.S. dollar, which is weak and getting weaker, could be a positive or a negative influence on stocks. On the plus side, U.S. goods become cheaper relative to foreign goods, which helps U.S. exports and the companies that manufacture them. On the down side, foreign investors find U.S. assets less attractive as the dollar deteriorates. A big movement of money out of U.S. stocks and bonds and into foreign securities would be negative for the U.S. markets.
Then there is always the possibility that the economic recovery could stall. Consumer spending could taper off along with mortgage refinancing, which has been a major source of cash flow for many families. Inflation doesn't look like a risk now, but commodity prices have risen as the dollar weakened, and oil prices are susceptible as long as there is instability in the Middle East.
And then there's the most frustrating factor for investors: major threats to stocks often come out of nowhere, from epidemics to terrorist attacks.
Many advisers and money managers have a conservative outlook for the new year.
"The market next year is going to be much more of a two-way affair," going both up and down, said money manager Robert Thompson at Bay Capital in Tampa. "The idea that the tide will lift all boats is probably not accurate."
He predicts a 6 to 8 percent return for stocks, possibly as much as 10 percent. A 10 to 12 percent return would be "very generous," Ferrara said.
Advisers try to add value by finding those sectors or stocks that will do better than the average market return.
Eric Bailey, managing principal for CapTrust Financial Advisors in Tampa, said he looks for blue-chip, dividend paying stocks to outperform.
"In 2003, the rally was led by junk, by lower quality companies that were really beaten up severely in the Nasdaq bubble," he said. "Next year, I think earnings and the market will be led more by quality."
Dividend-paying stocks are expected to be in vogue because the tax law change means investors will pay lower taxes on most dividends.
"In a recovering economy, the small stocks lead and the large companies follow along," Ferrara said.
Financial planner Doyle suggests investors consider putting a small part of their portfolios into commodities by investing in mutual funds that specialize in the sector. Oppenheimer and PIMCO are among the fund companies that have such offerings.
Money manager McIntosh suggests moving out of technology and into steel, aluminum and energy companies that stand to benefit from rising commodity prices.
"I think you're going to see the hard asset plays do extremely well in 2004," he said.
Many money managers also are encouraging investors to put a small part of their portfolios in foreign stocks, which will allow them to benefit from the weaker dollar.
While the past year may have been a breeze for investors, that doesn't mean they should forget the lessons of the previous three. Diversification is still important, and so is taking profits when a stock has had a big run.
"While they are feeling better today than they may have this time last year, we still have to remember that when we don't use our noggins to invest our money, we usually end up getting banged in the head," Ferrara said.
