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Today I will look ahead to 2005. Why so far down the road?

Because I think if you start planning now and make the right moves at the end of 2004, next year can turn out much better than many investors now fear.

That's not because Wall Street projections for 2005 are so rosy. Just the opposite, in fact. I'm relatively optimistic about next year, just because Wall Street is so pessimistic. In contrast to 2004, which began with Wall Street assuming that everything would turn out right after a great 2003, 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 overdone.

But before jumping too far ahead, first we need to better understand the current market rally and what it might tell us about the future. So what's driving stock prices up so strongly now?

It's All About Momentum

It sure ain't fundamentals. The Conference Board's 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 on to consumers.

And finally, Wall Street is predicting that we've passed the peak in earnings growth. Earnings for the stocks in the

S&P 500

are now projected to climb 17% in the third quarter that ended Sept. 30 from the same quarter in 2003, according to Thomson 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 just 8.1% in the first quarter of 2005. Stocks don't 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&P's 5.87% return for 2004. A 7% or 8% return may not seem that different from this number, 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 manager's relative performance against the index.

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The number of underperforming funds isn't 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 that 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 of this sets up the market for one of those classic Wall Street about-face moves. The momentum 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. I'd even say the lifespan of this rally is determined by the balance between Wall Street's fear of trailing the indices 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 won't last very far into 2005. 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% (that's 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.

It's Not All Bad News

It's 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?

  • A falling dollar gives U.S. companies protection from some imports, drives up exports and provides cover for modest price increases. I think this will turn out to be especially important for cyclical basic-materials producers in industries such as steel, because it means their earnings won't peak until 2006 instead of early 2005.
  • The Chinese finally yield somewhat to pressure and let the yuan appreciate modestly against the dollar. A cheap yuan is great for exports, but it kills the profitability of any Chinese company that has to import raw materials or components priced in yen, euros, Australian or Canadian dollars. That will take some pressure off the euro, keeping European growth rates higher than now projected, and it will give companies that compete with Chinese imports a little more breathing room.
  • The weak dollar and temporarily lower oil prices will give U.S. companies a solid shot at beating the low 8% consensus projection for first-quarter earnings growth. The figure won't be high enough to start talk of a new cycle of fast-growing corporate profits, but it will be enough to show that earnings and economic growth in general aren't about to fall off a cliff.
  • A slightly stronger yuan will help the Chinese government restrain capital imports and ratchet back growth without turning the Chinese economy into a train wreck. That, in turn, will lead to a gradual change in focus by investors from worry that Chinese growth will slow too much, too quickly to a renewed interest in companies that will profit from Chinese growth.

The rally that will result from that unexpected good news won't look or feel like the sharp growth rally that has characterized the end of 2004 so far. It's likely to resemble the stealth rally in the first half of 2004, when dull old basic-materials stocks, cyclicals and food stocks climbed ahead while the rest of the market treaded water.

Be Disciplined

And if all of this is true -- a big "if," I grant you -- investors who want to make and keep a profit will have to zigzag as the stock market does. That means riding growth stocks in the current rally but selling them when they hit your target prices or when the rally as a whole starts to feel long in the tooth and tired. It means sitting on cash for a while in 2005 to see if the correction that I think is likely in the first quarter of the year does materialize. And then it will mean redeploying that cash into value stocks, into cheap growth stocks and into the specific sectors that are most likely to benefit from a cheapening dollar.

If that strategy recommendation sounds familiar, it should. It's a replay of what worked in 2004. And the wild cards that could upset this strategy are largely the same as those which have hovered over investors for all of 2004: how fast oil prices rise after the current dip; how well or badly the war in Iraq goes; and how well or badly the Republicans use their increased power in Washington.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at