Market Outlook – 8 January 2005(A)
2004 started and ended with a bang, spending the intervening nine months in an extended if shallow slump. Thus did the market live up to its reputation for frustrating the largest number of people for the longest period of time. Those who took January’s gains as signs of a booming year to come–and a continuation of the heady gains of 2003–were quickly disappointed as the market topped out in February and proceeded to decline all the way into August.
This, of course, brought the naysayers out in force with predictions of both a renewed economic recession and a return of the bear market in stocks, memories of which had only started to fade. Spiking oil prices, chaos in Iraq, a tepid US employment picture and uncertainty over the presidential race all conspired to keep the market down almost to the end of October.
Only days ahead of the election, however, the markets began to stir as oil prices cracked and fell; solid 3rd quarter earnings reports rolled in; and cash sitting on the sidelines pending the election began to tiptoe into stocks. From October 25th through December 31st the S&P 500 went virtually straight up, rising 11% in nine weeks and sending the bears back to their caves.
Interest Rates and Inflation
Aiding and abetting stocks—and frustrating virtually every bond pundit in the land—long-term interest rates refused to move higher, closing the year unchanged with the 10-year US Treasury Note yielding 4.25%. The Federal Reserve did raise short-term interest rates from 1% to 2.25% during the year. But with the 10-year Treasury yield holding steady the net result was simply to “flatten the yield curve,” that is, pull short-term rates up closer to long-term levels. Such “flattening” is natural and reflects a less stimulative interest rate policy, which is appropriate now that the Fed has gotten the economy back on its feet.
This flattening of the yield curve is encouraging as it indicates a sanguine attitude about inflation on behalf of bond investors, who are notoriously sensitive on the subject. The bond market seems to understand that the Fed is raising short-term interest rates NOT to put the brakes on a runaway (inflationary) economy but rather to ease off the accelerator as the economy reaches cruising speed.
Contributing to the benign inflation outlook was the sharp drop in oil prices in late October and November, a move that reversed the upward spiral of only weeks before. This kind of nutty action has “HEDGE FUNDS” written all over it as these speculative vehicles turbo-charge the herds’ move into and out of the “hot” asset of the moment, whether oil or stocks or currencies. Long-term investors mustn’t confuse such speculative noise in the system with the true fundamentals of the situation.
We suspect something similar is at play in the currency markets, where the decline of the US dollar has taken the place of oil prices as the panic du jour in the press. It is a truism of markets that by the time everybody is scared about something the worst of it is usually over. We suspect this is the case with the US dollar, which is now trading at 30-year lows relative to many currencies. This puts dollar-priced assets of every stripe on a virtual fire sale to foreign buyers, which should increase foreigners’ appetite for US assets. In the debt markets the Fed’s actions last year pushed short-term US interest rates above those in Europe for the first time in over two years, which should also increase demand from foreigners for US debt instruments. Both of these factors should tend to support the US dollar, mitigating further declines.
The real dollar bears of course aren’t just grousing about another 10% decline in the dollar; they see a freefall prompted by wholesale liquidation of US assets by foreigners. This argument rests on the assumption that the largest foreign holders of US dollars–Japan and China–will seek to avoid the pain of further dollar declines by selling their US dollar holdings. As Japan’s and China’s dollar holdings are so large, however, they could sell only a small portion of their total position. That would suffice to drive down the dollar and with it the value of their remaining vast holdings. For Japan and China to sell dollars because they fear a further decline would be like pouring kerosene on a fire to put it out.
Over the coming year we expect to see the US economy grow at a moderate 3%-4% pace with inflation under control. The Fed will continue to gradually raise short-term rates to more normal levels, a process we foresee having a fairly modest impact on longer-term rates. This environment should promote continued profit growth among US corporations, though earnings are likely to grow roughly 10% in 2005 as compared to 19% in 2004.
Assuming 10% earnings growth for stocks next year and a roughly 2% dividend yield, one might conclude that stocks should return something around 12% for the year. However, as interest rates should rise, if only slightly, that’s likely to create a bit of a headwind for stocks in 2005. Adjusting for that headwind, we assume stock returns for the year will fall somewhere in the high single digits.
The upside surprise to this forecast would be if corporations begin to put their vast cash hordes to work—hiring employees, making capital investments, increasing dividends, buying back their own stock and/or buying out other companies. Any of these activities could potentially boost stock returns for the coming year. And, indeed, as 2004 ended we saw a flurry of super-sized corporate takeovers (Oracle/PeopleSoft, Sprint/Nextel) that seemed to hint at a growing confidence among corporate execs, or at least a growing impatience with sitting on cash.