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Markets: The Road Ahead
New York: December 27, 2004
By John R. Stephenson

So, what does the next year hold in store for investors? What are the issues that will define the investing landscape and how can investors profit? For 2004, two principal stories seemed to drive the stock market: 1) a sagging U.S. dollar and 2) surging oil prices. Outside of the stock market, real estate was the other big story with U.S. house prices surging some 13% by the end of the third quarter of 2004. If you were fortunate enough to hold property in Nevada (a 42% gain this year), California (27% gain) and Washington D.C. (23% gain) you would have made out like a bandit.

Whether it is the housing sector or the stock and bond markets, the story appears to be the same - it costs a lot more dollars to own stock, gold, oil, bonds or houses than we think it should. In other words, valuations seem a little stretched. Over the past year, investors seem to have thrown caution to the wind and bid the prices of cyclical stocks, small cap stocks, houses and poor credits way up. While stock prices have risen over the past year, dividends (while up) have not kept pace and currently only yield 1.6% on average - an historic low. With enthusiasm high and prices elevated, we anticipate a difficult path for stocks, bonds and real estate in the New Year.

The next year will likely be comprised of two stories for stock market investors. The first half of the year is likely to be rocky as the stock market digests the implications of past and future interest rate hikes by the U.S. Federal Reserve (U.S. central bank) and the slowing of corporate earnings. During such times of transition the market typically rewards investors who invest in stable-sectors and dividend paying (income) stocks. Once the Fed slows its tightening cycle or the market sees light at the end of the tunnel, there could well be an impressive rally in the stock market.

While we expect gains in the stock market over the coming year, these gains are likely to be considerably smaller than in previous years. The reason? Corporations have turned in some strong numbers over the past few years in terms of revenue and profit margin growth that will likely be difficult to sustain in the future. Almost half the gains in the S&P 500 (a leading market index) are the result of strong performances by the financial service sector and the energy sector. By contrast, the pharmaceutical industry cost the S&P 500 index about 13 points and overshadowed the gains by other companies in the health care sector.

Currently, the estimated earnings multiple on the S&P 500 is 17.1 times for the next twelve months. That might seem to be a very reasonable multiple to many investors, particularly when you consider that only five years ago the forward multiple on the index was 24 times. But back then, the vast majority of the stocks were reasonably priced and only a few companies were really exorbitantly expensive which dragged the multiple higher. Today, it is a different story with the vast majority of companies over valued and hence the overall index is valued above its one hundred year historical average of 14 times. As well, research has established that stocks perform best and exhibit strong revenue and margin growth when they are coming off depressed levels.

With stock valuations looking a little frothy and with the possibility of slowing markets in the near term, we believe that for the start of 2005, investors should move toward a more defensive posture in their portfolios. Consider reducing your exposure to stocks to no more than 55% and keep at least 25% of your portfolio in cash and wait for buying opportunities. Some of the areas that look attractive are energy which should benefit some more from a declining U.S. dollar and a tight supply/demand balance as well as utilities that are defensive in nature and offer good dividend yields.

Figure 1: Performance and Valuation Estimates

Source: Banc of America Securities, Thomson Financial


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