Stocks in 2004? A jet needs fuel

Outlook: The direction of interest rates, corporate earnings and the value of the dollar are among important considerations for investors looking ahead.

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January 18, 2004|By Bill Barnhart

As voters trudge off to the Iowa caucuses, investors are asking if they will be winners when the presidential election year ends.

Four years ago, stocks sold off during the long count between George W. Bush and Al Gore, helping push the market lower.

Barring a repeat of the recount debacle or the Nasdaq market collapse, which characterized 2000, a case still can be made that this election year will be just so-so on Wall Street.

Jeremy Grantham, chairman of investment managers Grantham, Mayo, Van Otterloo & Co., finds a predictable pattern of restraint in the first two years of the term and stimulus in the final two years, as the next election nears.

"I'm a new devotee to the power of politics in the stock market," he said. Politicians "know what they're doing. It's amazing to me. I didn't think politicians got anything right."

Said Bruce Bittles, chief strategist at investment banker R.W. Baird: "Typically, the market does well in the election [but] not as well as the pre-election year. The average gains are about 12 percent or 13 percent in an election year."

The last year an incumbent Republican won re-election was 1984, when Ronald Reagan handily defeated Walter Mondale. The prevailing forecast for 2004 calls for a repeat of the Republicans' 1984 victory. But stocks were flat that year, as the widely predicted outcome failed to inspire investors until 1985. There tends to be less buyers' remorse among investors when the Republicans retain the White House. By contrast, stocks fell sharply in November 1948 after Harry Truman won.

But this time, stock market skeptics say the Bush administration and Federal Reserve have stoked the economy so strongly, with tax cuts and cheap money, that inevitable austerity after the election will disappoint investors.

A more optimistic view says the stimulative effects of current fiscal and monetary policy will sustain the rebound.

Here are four important considerations for investors in this election year:

Corporate profits

Analysts do not expect the strong growth in profits to persist. "As the year wears on, the ice gets thinner," Grantham said. "The odds of doing well are better in the first half ... than the second half."

The effects of last year's economic and fiscal stimulus will wear off month by month in 2004, he said. Moreover, strong profit results in the third and fourth quarter of 2003 will make percentage comparisons more difficult for companies in the second half of this year.

But the stock market looks forward, he said. Declining profit growth this year may not diminish investor enthusiasm for the years ahead.

Interest rates

The consensus on Wall Street sees long-term interest rates slightly higher by year's end, curtailing mortgage activity and slowing the economy. Higher interest rates erode demand for stocks, because higher rates increase corporate expenses and provide investors with an attractive alternative to equities.

But last month's weak jobs report and low inflation have prompted many forecasters to postpone the onset of higher interest rates.

"For most of the year, rates will stay around 4.5 percent," Bittles said. "Bonds are behaving better than we expected at this stage."

"The risk is that China and Japan will sell Treasury securities," said Charles Callard of Callard Asset Management. Declining demand overseas for U.S. Treasuries would force interest rates higher.

Dollar trend

In 2003, the weak dollar in foreign currency markets helped boost profits for U.S. multinational companies. The cheaper dollar permits them to post higher revenues and profits from non-U.S. operations.

The fear is that the dollar's slide will not subside but instead will erode confidence in U.S. investments and force interest rates higher.

Said John Llewellyn, global chief economist for Lehman Brothers, "Foreigners are not investing in the U.S. on quite the scale they were."

Expectations for 2005

"Next year is awful," said Grantham. "I'm looking out at the black hole of '05 and '06."

Grantham expects the party will be over, as the government reins in investor-friendly policies. "Speculators take their risk in years three and four [of each term]," he said. "In the years one and two, the message from the administration and the Fed is the opposite, and you should avoid risk."

If the trend in the dollar plays out as it did from 1985 to 1988, investors could be in for a rough ride after this election year, Llewellyn said.

Then, as now, a decline in the dollar prompted statements of concern. International pressure swelled on the United States to reduce trade deficits. But efforts to halt the dollar slide failed, helping spark the crash of 1987.

Bill Barnhart is a financial columnist for the Chicago Tribune, a Tribune Publishing newspaper.

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