2 Factors May Steer Wall St. This Year

It’s 2005 on the calendar, but what year will this be on Wall Street?

Some investment pros are thinking about 1994, when the Federal Reserve began to slowly raise short-term interest rates, then sharply stepped up the pace of credit tightening -- to the bond market’s horror.

Others are thinking back to 1977. In 1973 and ‘74, the stock market suffered its worst decline since the Great Depression, only to snap back in 1975 and ’76. (Sound familiar?) But high hopes for 1977 were dashed by rising inflation. The Dow Jones industrial average fell into another bear market that year.

Or maybe this will be just like all other mid-decade years: Since 1915, every year ending in five has been positive for stocks, and in all but one of those years the Dow Jones industrial average rose by more than 20%.

Investors typically feel a mix of hope and anxiety at the start of each January. Last year at this time, however, hope probably exceeded anxiety for many people because stocks had rebounded dramatically, the Fed still seemed a long way from raising interest rates and there was no talk of a crisis for the U.S. dollar.

By contrast, as 2005 dawns, many investors may wonder how their portfolios made it through 2004 in such reasonably good shape -- and whether their luck will hold out in the new year.

Last year, the Fed started raising rates for the first time since 2000, the price of oil soared, the dollar plummeted and insurgents in Iraq took a heavy toll on U.S. and Iraqi security forces, raising concerns about that nation’s future.

Yet every major U.S. stock market index posted gains for the year. So did most foreign equity markets.

The Dow Jones industrial average added a modest 3.2% to end the year at 10,783.01. But the underachieving Dow was a poor proxy for the rest of the market.

The Standard & Poor’s 500 index rose 9%, and the technology-heavy Nasdaq composite gained 8.6%. Indexes of smaller stocks fared even better: The S&P; small-cap index surged 21.6%.

As for bonds, long-term interest rates were amazingly restrained even as the Fed raised its benchmark short-term rate five times. The result: Most bond mutual funds had positive total returns (interest earnings plus or minus principal change).

Can 2005 top all that?

That may depend on two major factors, and an assortment of wild cards:

* Major factor No. 1: Inflation. It’s up. And if the trend continues in 2005, inflation could be the most important determinant of what happens in financial markets.

In the first 11 months of 2004, the government’s consumer price index rose at a 3.7% annual rate, nearly double the 1.9% rise for all of 2003.

Strip out food and energy prices, and the “core” inflation rate rose at a 2.3% rate in the first 11 months, compared with 1.1% in 2003.

Rising inflation is the bond market’s worst enemy. It makes suckers out of people who buy long-term bonds because it erodes those fixed returns.

Then why did long-term bond yields fall in the second half of 2004, after climbing in spring? Here’s the answer most economists and bond market veterans give: Some investors were willing to accept lower bond yields because they figured the Fed was on guard against inflation, as the central bank raised its key short-term rate from a generational low of 1% in June to 2.25% by mid-December.

By late summer, many bond traders figured the economy was more likely to slow than speed up. That also kept a lid on long-term rates.

Demand for U.S. Treasury bonds by Asian central banks, recycling their record-trade-surplus dollars, was another factor.

So 2004 ended with the 10-year Treasury note yield at 4.22%, slightly below its close of 4.25% a year earlier.

But that raises the stakes for bonds in 2005. If inflation continues to accelerate, bond investors are bound to notice. They eventually would demand higher yields to compensate. That would cause the value of older bonds with lower yields to decline.

Rising inflation also could force the Fed to give up its plan to continue raising short-term rates at what it calls a measured pace -- a quarter-point every six to eight weeks. The Fed might have to make some half-point increases. In November 1994, the central bank was in such a hurry to raise rates that it even made one three-quarter-point increase.

For now, most analysts think inflation won’t surge, and that the Fed can continue to tighten credit slowly. Steven Wieting, economist at Citigroup Global Markets in New York, figures the Fed’s key rate will be 3.5% to 4% by the end of 2005.

“They’ll go higher, but they can take their time,” he said.

Regardless of whether they believe inflation is under control, most people on Wall Street think long-term interest rates are going up this year. In a Merrill Lynch & Co. poll of money managers worldwide in early December, 60% said they expected rising inflation in 2005, and 78% expected long-term rates to be higher in 12 months.

To buy bonds at current yields, therefore, is to make a bet that you know something the crowd doesn’t. True, the crowd in any market often is wrong. But sometimes they get it right.

* Major factor No. 2: Corporate earnings. Nearly everybody on Wall Street figures that earnings growth will slow in 2005. In fact, profit growth has been slowing since the first quarter of 2004.

Yet the stock market went up last year. Bullish investors think the same can happen in 2005, even if profit gains decelerate further, and even if the Fed keeps raising interest rates.

Here are the numbers: Operating earnings of the S&P; 500 companies are estimated to have risen 19.2% in 2004, according to analysts’ estimates compiled by earnings tracker Thomson First Call in Boston.

For 2005, the increase in earnings from 2004 levels is projected to be 10.5%. That would be slower growth -- but still growth. So the absolute level of earnings backing up stock prices should be higher at the end of this year.

Based on the estimated overall profits for the S&P; 500 in 2004, the average stock in the index has a price-to-earnings ratio of about 18.

That is well below the peak price-to-earnings ratio of about 25 when the last bull market reached its zenith in 2000. But at 18, few people on Wall Street say stocks are cheap. “Fair” is the word most often heard.

Assume that 18 times earnings is the most investors are willing to pay. If earnings rise 10.5% in 2005, in theory stock prices could rise by that amount too, to keep the average P/E at 18.

The question is, would investors continue to see that as a fair P/E? It might all depend on what happens with interest rates. If they were to rise significantly, investors probably would lower their opinions of stocks’ values. So anyone who expects the Fed and the bond market to be aggressive in pushing up rates this year has to be nervous about stocks at these levels.

Investors also would think less of stocks if they assumed a recession was coming in 2006 and, with it, lower earnings.

But if the assumption is that the economy, and earnings, still will be growing in 2006, it isn’t too difficult to imagine the stock market providing better returns in 2005 than what bonds or short-term cash accounts generate, many market pros contend.

Consider: If the Fed’s short-term rate is at 3.5% by the end of 2005, even if stocks were to gain just 5% they would beat cash accounts.

Chip Dickson, a stock strategist at Lehman Bros. in New York, figures the S&P; 500 can rise 7% this year if earnings come through. And there’s always the possibility that companies’ results will be better than what executives now are suggesting to Wall Street, he said.

In the post-bear-market environment, “managements are being more cautious” in their outlooks, Dickson said. But that just makes it easier for companies to beat analysts’ estimates.

* Wild cards. Anything could be a wild card in terms of affecting markets, but some are potentially wilder than others.

China is a big one, of course. Last year, many investors finally came to realize the effect China’s booming economy was having on the rest of the world. A major reason for the surge in world oil prices was Chinese demand. Ditto for other commodities.

The Chinese government is trying to slow the economy. If it succeeds, commodity prices could fall. That could be bad news for commodity producers but good news for consumers.

The weak dollar also has risen close to the top of investors’ concerns. Most on Wall Street figure the dollar will continue to fall in 2005, weighed down by the nation’s budget and trade deficits. The fear is that a dollar crisis could ensue -- meaning a rapid plunge of the currency that could badly shake up financial markets worldwide.

That still seems unlikely, but it’s no longer as far-fetched as it may have been a year ago. In any case, few investors are going to stay out of markets because of the dollar’s woes. And the assumption still is that a weaker dollar will help American exporters anyway.

Finally, there is the ever-present risk of a terrorist attack, or that Iraq could collapse. Wall Street hasn’t forgotten about the terrorism risk, but neither is it as obsessive about it as, say, two years ago. And if the assumption is that an attack could happen, then by definition it couldn’t take investors totally by surprise, as the events of Sept. 11, 2001, did.

The Iraq situation has come to be viewed in a similar light: The risks there “are becoming more obvious to investors,” said Christopher Wolfe, research chief at investment firm Dover Management in Greenwich, Conn. That means developments there are less likely to shock Wall Street.

Surveying the various opportunities and challenges facing investors and markets in 2005, Wolfe comes to a similar conclusion as many other pros: All in all, the stock market may continue to offer the best return potential relative to the risks.

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Tom Petruno can be reached at tom.petruno@latimes.com.