Barring any 11th hour surprises, it appears that the market will end 2004 on a high note as the stock market has finally broken out on the upside in the final quarter of the year. This recent advance begs a few questions. One, will this upward trend continue into 2005 and if so how much more upside exists? Second, will the trading range environment return, which should make prudent investors a bit cautious as we enter the New Year? I think these are the major questions to answer in order to develop a successful investment strategy for the next twelve months. In this year-end edition of Willingdon Views we’ll try to examine each question and provide our best sense of what to expect from the stock market in 2005.
The start of an earnings slowdown… I think it is fair to say that earnings growth will slow markedly in 2005. Based on current estimates the S&P 500 earnings growth should approximate 18% in 2004 but only 6% in 2005. Given this deceleration in earnings growth, other drivers have to emerge in order to sustain the recent advance in share prices. What might some of these be? One potential catalyst could be a positive development in the war on terrorism. Bagging bin Laden, or meaningful progress toward sustainable peace in Iraq, enabling the withdrawal of U.S. troops, would definitely provide an upward boost to investor sentiment. Unfortunately, the geopolitical scene is always a double-edged sword. A major terrorist attack or mounting U.S. casualties could just as easily lead to a market correction.
Historians wait with pen in hand… Domestically, another potential catalyst could be measurable progress toward reducing the trade and federal deficits. Only time will tell whether the Bush administration can deliver upon campaign promises to alleviate the fiscal imbalances that trouble many economists. The stakes are high as most investment professionals agree that President Bush’s legacy will reflect his success on these two fronts. First, winning the global war against terrorism and bringing our fighting men safely back home. Second, reversing the record trade deficit and lowering the federal debt without burdensome tax increases.
The historians will ultimately record the outcome of this interesting political debate. Meanwhile, there is a distinct possibility that neither the geopolitical scene nor the twin deficits will become market drivers in 2005. We may just muddle through on both fronts, ending 2005 facing the same challenges in front of us today. In any event it is difficult, if not impossible, to predict the timing and ultimate outcome of either issue. Hence, it may be a futile exercise to develop an investment strategy for 2005 that hinges upon a particular outcome on the geopolitical or domestic front.
Which leaves the market stuck in a trading range… 2005 may be a year without a sustainable market driver. If this forecast proves accurate, fundamental analysis, disciplined valuation methodology, and stock picking acumen will once again serve as critical determinants of portfolio performance. At the same time it is always important to anticipate events that could jump start the next market rally.
Consolidation is one idea to ponder… 2005 may be a year in which mergers and acquisitions heat up as corporations search for ways to accelerate their earnings growth while finding more productive uses of their mountainous cash flow. It is interesting to note that corporate cash levels are at an all-time high. I think health care is one industry that could be ripe for consolidation given the strong cash flow and scarcity of organic growth at many large firms.
One risk to be wary of… One primary risk that could make 2005 a difficult year is the potential threat of a steep drop in the U.S. dollar. A gradual, more orderly depreciation in the U.S. dollar should not have ill effects for the overall market. However, a precipitous drop could very well spook the market causing a painful correction. I do not think this is the likely scenario as none of our global trading partners want to see this happen and would likely support the U.S. dollar if it started to depreciate more rapidly.
Not to forget Elliot… Now that Mr. Spitzer has made his political aspirations clear, my sense is that the market has seen the worst of his attacks. The changes that he has forced toward more transparency and disclosure will continue to create more level playing fields across various industries. By in large these developments are positive for top quality companies who compete most successfully on a level playing field. Based on this, I do feel a continued flight to quality in 2005 is likely.
To sum it all up, at this point we don’t expect a lot from the stock market in 2005. Maybe we’ll be pleasantly surprised. Whatever does transpire, as we enter our second year, we intend to keep you informed through future editions of Willingdon Views.
Until then, thank you for your loyal support and we wish all a joyous and prosperous 2005.
