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Stocks, Bonds Surprising in ’04

Times Staff Writer

Wall Street is hoping for a strong finish to a year that is turning out surprisingly well for financial markets.

Despite rising interest rates, a plummeting dollar, a sharp jump in energy prices and slowing corporate profit growth, Americans are on track to make good money this year in the bread-and-butter investment categories of stocks and bonds.

Things could always go wrong in December. But the calendar is on the side of the bulls: Investors typically have been an optimistic bunch in the last month of the year.

The blue-chip Standard & Poor’s 500 stock index has risen in nearly three-quarters of the Decembers since 1950, according to the Stock Trader’s Almanac, which tracks market trends. The average December gain for the S&P;: 1.6%, making it the second-best month of the year historically (after November, at 1.7%).

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For long-term investors, one month’s performance shouldn’t matter much in the scheme of things, of course. But there may be more than usual riding on the markets’ trend this December, particularly for equities.

The bearish view on Wall Street at the start of this year was that the rebound in share prices in 2003 was a flash in the pan -- a brief respite within a prolonged slide.

If stocks can hold on to decent gains in 2004, the market will have rewarded investors for two straight calendar years. That wouldn’t erase the pain of the severe decline of 2000-02, but it could bolster confidence that the market has moved on, and that the risks of owning stocks don’t drastically outweigh the potential rewards.

This year, the biggest surprise to many investment pros has been the breadth of the stock market’s advance, meaning that people have found reasons to buy shares across an array of unrelated industries.

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You wouldn’t know that from looking at the Dow Jones industrial average, the most widely followed market index. It has been a poor proxy for what has gone on in the market as a whole.

The 30-stock Dow, at 10,522.23 on Friday, was barely positive for the year, up 0.7%.

But the Dow is the anomaly, not the norm. The average New York Stock Exchange issue has risen 9.4% this year. The average small-company stock has jumped 13.3%, as measured by the Russell 2,000 index.

Within the S&P; 500 index, 85 stock industry sectors are in positive territory this year, while 28 have lost ground.

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That has made it easier for stock mutual fund managers to keep their investors in the green: The average domestic stock mutual fund has gained 8.6% this year, according to research firm Morningstar Inc.

The story also has been unexpectedly good for bond mutual funds. Although the Federal Reserve has raised its benchmark short-term rate four times since June, to the current 2%, long-term interest rates have declined since then. That has reversed much of the damage done to the principal value of older fixed-rate bonds in the first half of the year, when long-term rates surged.

The average long-term bond fund has posted a total return (interest earnings plus or minus principal change) of 5.3% year to date, according to Lipper Inc.

Those returns stand out when compared with returns on cash accounts, such as money market mutual funds. The Fed’s credit-tightening campaign has lifted returns on cash, but investors who are playing it safe in money funds still are earning very little -- 1.37% at an annualized rate, based on the average fund yield as calculated by ImoneyNet Inc.

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For some equity investors, this year has been so profitable that the question of what to do next -- buy, sell or hold -- has become much more difficult than it was, say, in June.

Do you stick with what’s working but is perhaps now overpriced? Or do you buy stocks that have fallen, hoping for a bargain?

Hot stock sectors always have a fundamentally good story underpinning them. But as the story becomes more widely known, and the stocks rise further, the danger is that the fundamental story takes a back seat to simple “momentum” investing: Many new buyers are jumping aboard simply to ride the rally as far as it goes, not because they are true believers in the industry’s prospects.

Momentum investing can become a bigger factor in the market as the end of the year approaches, as professional portfolio managers seek to boost their returns by buying what’s hot, hoping for a short-term windfall.

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Given the number of stock sectors that have scored large gains this year, and the strength of the market heading into December, “I think you’re going to see a lot of performance chasing,” said Marc Pado, U.S. market strategist for brokerage Cantor Fitzgerald in New York.

The steel sector could be particularly vulnerable to a pile-on. The average steel stock in the S&P; 500 has soared 64% this year. The shares enjoyed another strong rally on Friday, after Japanese automaker Nissan Motor Co. said it would temporarily shut many of its plants because steel is in short supply worldwide.

There’s the fundamental story: Sales of steel are robust, in part because of heavy demand from China. That should give steelmakers greater pricing power and thus boost their earnings potential.

Yet so far, Wall Street analysts are figuring that earnings at some steel companies will be lower in 2005 than in 2004.

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U.S. Steel Corp., for example, is expected to earn $6.65 a share in 2005, according to the average estimate of analysts surveyed by Thomson First Call. That is down from the 2004 estimate of $7.43 a share.

Why buy shares of a company whose earnings are headed lower? It may be that many investors believe analysts are underestimating the industry’s earnings power. Or investors may be figuring that with U.S. Steel’s share price at $51.25, even if the company earns $6.65 a share next year the stock’s price-to-earnings multiple of about 8 is a relative bargain.

A P/E of 8 does look very low compared with the S&P; 500 index’s P/E of about 16, based on analysts’ average estimates of 2005 earnings for blue-chip companies. But investors who are looking at steel stocks for the first time may not realize that the shares virtually always sell for low P/Es -- because their business is (or at least has been) a classic boom-or-bust story.

Ditto for many transportation companies, which like steel firms have attracted a swarm of investors this year. Driven by railroad and trucking shares, the Dow transportation stock index is up 21.3% year to date, to a five-year high as of Friday.

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Contrast that performance with what has happened to some of the classic growth stocks of the last decade. Shares of Coca-Cola Co., Merck & Co., Cisco Systems Inc. and other 1990s highfliers have fallen sharply this year as investors have lost faith in their longer-term growth prospects. That’s a big reason for the Dow Jones industrial average’s poor showing.

Fans of those stocks say that if the shares aren’t bargains yet, they’re getting close. Russ Kinnel, director of mutual fund analysis at Morningstar in Chicago, makes the argument that many classic big-name growth stocks are looking like technology stocks at the beginning of 2003 -- so unloved that they must be near a bottom.

But guessing what “near” means is the hard part. What if the economy shines in 2005, and the story for steel, transportation and other economy- sensitive sectors just gets better?

Wall Street optimists say the starting point for their general bullishness about stocks is the bet that the economy will continue to grow, and that the various calamities feared by the bears -- a sudden crash in the dollar’s value (as opposed to the slow-motion crash now underway), for example, or a surge in inflation -- will fail to materialize.

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If that’s the environment in 2005, “stocks are clearly the favored investment alternative,” said Timothy Morris, a senior manager at Bessemer Trust Co. in New York.

As for individual industry sectors and specific stocks, in this second year of a bull market many investors are again faced with the harsh reality that there is no magic formula for determining when to buy, when to hold and when to let go.

Those who are fortunate enough to be sitting on large stock gains this year will have to go with their gut in deciding what to do next.

When in doubt, it’s always good to remember one old bit of Wall Street advice: No one ever went broke taking a profit.

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Or to approach it from a different angle: If a stock has done in one year what you hoped it might do in three or four years, it may be time to reconsider how much better it can get.

Tom Petruno can be reached at tom.petruno@latimes.com. For previous columns, visit latimes.com/petruno.

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Bull’s progress

Most major stock market gauges are showing hefty gains this year. The Dow-30 index is the exception.

Stock index, year-to-date gain

Dow utilities: 25.0%

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Dow transports: 21.3%

Russell 2,000: 13.3%

S&P; mid-cap: 11.2%

NYSE composite: 9.4%

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S&P; 500: 6.4%

Nasdaq composite: 4.9%

Dow 30: 0.7%

Source: Bloomberg News

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