Jubak's Journal
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Set yourself up for a stellar 2005
The current momentum market dominated by growth stocks wont last very far into 2005. But a little planning now will go a long way in securing profits in the year to come.
By Jim Jubak
Today Im going to look ahead to 2005. Why look so far down the road?
Because I think if you start planning now and make the right end-of-2004 moves, 2005 can turn out to be a lot better than many investors now fear.
Thats not because Wall Street projections for 2005 are so rosy. Just the opposite, in fact. Im relatively optimistic about 2005 just because Wall Street is so very pessimistic. In contrast to 2004, which began with Wall Street assuming, after a great 2003, that everything would turn out right, 2005 is likely to begin with a huge reservoir of fear. And I can see a couple of areas where the current pessimism is, if not wrong, at least over-done.
But before jumping too far ahead, we need first to better understand the current market rally and what it might tell us about the future. So whats driving stock prices up so strongly in the current rally?
Its all about momentum
It sure aint fundamentals. The Conference Boards composite index of leading economic indicators, which economists use to forecast growth, was down in October for the fifth month in a row. The conventional explanation is that the index is signaling a slowing economy and a weak 2005. The core Producer Price Index, which excludes volatile food and energy prices, climbed an unexpectedly strong 0.3% in October, raising fears that inflation at the producer level could be ticking up to levels that would have to be passed onto consumers.
And, finally, Wall Street is predicting that weve passed the peak in earnings growth. Earnings for the stocks in the Standard & Poors 500 Index ($INX) are now projected to climb 17% in the third quarter that ended Sept. 30 from the same quarter in 2003, according to First Call. Sounds great -- except that it would be the first time this year that earnings growth has dropped from one quarter to the next. Wall Street projects that trend continuing in the fourth quarter of 2004 and extending into 2005. Projections for the fourth quarter of 2004 call for earnings growth of 15.3% and then of just 8.1% in the first quarter of 2005. Stocks dont command higher prices when earnings growth is slowing, especially when interest rates are climbing.
Instead of fundamentals, this rally is based on momentum feeding on momentum. Once the market moved upward on a mixture of relief that the election was over and joy at lower oil prices, sitting on a pile of cash became much less attractive. The more the stock market goes up, the more pressure money managers feel to join in. And the more money they put into stocks, the higher stock prices go, increasing the pressure to put even more money into equities.
Look at mutual funds to understand the nature of this pressure. Of the 3,447 mutual funds in the MSN Money database that invest in stocks of large- and medium-size companies, 43% are trailing the S&P 500. The pressure is on these fund managers to at least catch up with the S&Ps 6.44% return for 2004 (as of Nov. 18). A 7% or 8% return may not be that different from 5%, but the difference is enough to swing a manager from beating the index to trailing the index. Bonuses and contracts to manage millions of dollars may hinge on a managers relative performance versus the index.
The number of underperforming funds isnt scattered randomly across growth and value styles, or across large- and mid-cap funds. Only 11% of mid-cap value funds are trailing the S&P and only 15% of large-cap value funds are lagging the index. But even with the recent rally, 40% of mid-cap growth funds and a whopping 75% of large-cap growth funds are trailing the index. The pressure is really on the growth managers to close that gap.
Is it any wonder the stocks that are climbing in this rally are the kind of growth rockets (or growth-rocket wannabes) that these growth stock managers are most familiar with?
Reversal of fortune
All this sets up the market for one of those classic Wall Street about-face moves. The momentum that is fueling the current rally will work only as long as investors willfully ignore the bad news that current consensus projections show coming down the road in 2005. Id even say the lifespan of this rally is determined by the balance between Wall Streets fear of trailing the indexes for 2004 and its fear of the expected bad news of 2005.
This argues that the current momentum market dominated by growth stocks and growth-wannabe stocks wont last very far into 2005. (How far into 2005 depends on what money managers do with the seasonally large cash flows that result from end-of-year contributions to IRAs and 401(k)s that are available for investing in stocks in January.)
And it argues for the likelihood of a strong correction after the first of the year, as money managers lose their motivation for buying stocks. Once the Dec. 31 performance figures are in the can, the fear of trailing the index for 2004 vanishes. Cash stops being a drag on performance in 2004, and turns into an insurance policy (again) against the fears of 2005.
The stronger the rally this year, the deeper the correction is likely to be as money managers decide to take profits on overvalued stocks, and particularly on the overvalued growth stocks that led the rally. Any correction will develop its own momentum, a negative image of the momentum now driving this rally. Many investors will see any fall in stock prices beyond 5% (thats halfway to the 10% threshold that serves as one traditional benchmark of a market correction) as confirmation of their worst fears for 2005, and as a sign to sell. The lower stocks go, the stronger that fear will get.
Its not all bad news
Its just at that point, however, that investors with a longer view of the fundamentals of the global economy will want to start buying stocks. Not the growth-stock winners of the last rally of 2004, but stocks that will benefit from the now-unexpected good news of 2005.
What is that potential good news?
Continued on Page 2
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