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stocks poised for yet more gains in 2005

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    a copy of Duskin article

    President Bush's re-election will bolster stocks in 2005. Some investors like the outlook for this year because they anticipate a continuation of the president's tax-cutting, pro-business and investor-friendly policies.

    If stocks do extend their gains this year, that would mark three straight years of an upswing in key indices such as the S&P 500 index, the Dow Jones industrial average and the Nasdaq composite index.

    The favorable outlook does not mean the economy, investors and the nation's stock markets can just relax and tap the cruise control button. Rising interest rates, the possibility of inflation, the sinking dollar and the lingering budget deficit, combined with jitters over terrorism and uncertainty in the Middle East, will require investors to remain alert as they steer their finances.

    The president's re-election, along with the shifts in the economy, seems likely to affect investors in a host of ways.

    Tax cuts and less regulation could affect fledgling companies and encourage entrepreneurs to launch businesses or scout for new technologies. A congressional and presidential agreement to drill for oil in Alaska and other regions could bolster energy companies. A quest to control the deficit could buttress the falling dollar. An expanding economy might be a further boost for high-tech and other companies. Rising interest rates may dampen the housing market and bonds, and possibly make the dollar more attractive.

    In 2004, investors were able to largely put the dismal losses of the bear market firmly in the rear-view mirror. Now, analysts like the odds that 2005 will produce a third straight year of positive returns for investors -- depending on what kinds of investments they pick.

    "I think 2005 will be a good year for stocks and a poor year for bonds," said Donald Luskin, the Menlo Park-based chief investment officer with Trend Macrolytics, an economics and consulting firm.

    The potential for gains this time around is not based on the speculative exuberance that produced the tech bubble of the late-1990s. Instead, analysts believe, the propellant appears to be solid economic growth, reasonable stock valuations, and the possibility of government policies that would favor investors, businesses, job creation and a continued expansion of the nation's economy.

    "Everything is in place for a great year for equities," Luskin said. "We have relatively low valuations for stocks, a very robust, sustainable economic recovery. And with the re-election of President Bush, we have the continuation of economic policies, such as making the tax cuts permanent, that have been responsible for a very strong recovery."

    What's more, Luskin is convinced that the policy initiatives on which the president campaigned could provide a short- and long-term boost for the economy and stocks. Among those are reform of Social Security, which will lurch into insolvency without some sort of overhaul.

    "There wouldn't be an immediate effect on stocks, but by dealing with this problem that has been under the radar but getting worse and worse, it takes away a very large long-term risk for the economy," Luskin said. "When the Social Security time bomb has been defused, people will become more willing to invest in stocks."

    Another analyst, John Valentine, president of San Ramon-based Valentine Capital, thinks observers will be surprised at the strength of the stock market in 2005.

    "People say we're going into a double-dip recession. But I don't see it happening," Valentine said. "There could be double-digit returns for the stock market in 2005. There are a lot of solid companies, strong companies, that were left behind in 2004 that can catch up in 2005."

    Other analysts agree in a rosy outlook for the stock market.

    "We're still creating jobs, the economy is growing at a measured pace, and inflation is relatively benign," said Nicholas Cochran, an investment adviser with American Investors Co. in San Ramon. "All of those things augur well for investing in equities, driven by improving earnings."

    Nevertheless, some market watchers warn that stocks may tip-toe along an economic high wire in 2005.

    "I'm rationally exuberant," said Eric Flett, a portfolio manager with Bay Isle Financial in Oakland.

    Flett believes the economy must be quite adept and dodge both a slump and roaring boom if the stock market is to perform nicely in the coming 12 months.

    "We need what I've been calling the Goldilocks scenario," Flett said. "If the economy is too hot and interest rates go up too dramatically, we will have problems. If the economy is too cold, the markets will struggle. Interest rates hold the key."

    Financial advisers and economists have differing views about how interest rate scenarios will play out in 2005.

    Some believe inflation will remain tame, while others are worried that inflationary pressures from the federal budget deficit and the national trade deficit, coupled with the falling dollar, could force interest rates even higher.

    "Inflationary pressures continue to build, and interest rates will continue to climb," said Brian Wesbury, an economist with Griffin, Kubik, Stephens & Thompson Inc., an investment firm. "Long-term rates are due for a sharp increase."

    The rise in interest rates could be severe enough that the bond market could look quite bleak.

    As interest rates rise for a U.S. Treasury note, the price, or principal value, of the bond erodes.

    "Bond prices have been held up, and bond yields held down, by the Federal Reserve, which has been trying to stimulate the economy," Luskin said.

    The Fed had a free hand to pursue such a policy as long as inflation was in check on all fronts.

    That was true during the recession and sluggish recovery. Until quite recently, companies could do little to raise prices and workers were not in a position to demand higher wages.

    Things are starting to change because the economy is in the middle of a healthy expansion.

    "Now we see sharply rising energy prices, food prices, higher prices for commodities such as metals, and a falling dollar in foreign exchanges," Luskin said. "Either the Fed will see the inflation risk and let the bond market know, or the bond market will see the inflation risk and let the Fed know. Either way, interest rates are going up."

    And that means investors might be unwise to continue to snap up government bonds, said Bruce Bartlett, a senior fellow at the National Center for Policy Analysis.

    "Investors might be well advised to lighten up on their bond portfolios," Bartlett said. "And if they don't have a fixed-rate mortgage, they should move to one very quickly."

    Even with the prospect of rising interest rates, Wesbury believes the nation's economy will grow at a brisk rate.

    "We will see real growth in the economy in excess of 4 percent, continued strong gains in employment, and some inflationary pressures," Wesbury said.

    That expansion, Wesbury is convinced, will be sufficient to underpin another fine year for corporate profits -- and stock prices.

    "The equity markets today are undervalued by 30 percent," Wesbury said. "We will see double-digit earnings growth and a gain of more than 20 to 25 percent for the stock markets. A 12,500 Dow or a 13,000 Dow is well within the realm of possibility."


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