Bulls and bears disagree on why markets were so rosy in 2003. And while they differ on the relative health of the market, they draw surprisingly similar conclusions about the market outlook for 2004 -- things are looking up.

Bullish participants say the rally that lifted the S&P 500 22.1% through Dec. 12 was the genuine return of a new bull market, fueled by strong economic underpinnings and a revival in earnings growth. Bears say the past year's gains represent an impressive bear-market rally sparked by one of the most overwhelming stimulus programs in economic history.

Despite the disagreement, many on both sides feel the market rally will be sustained for much of 2004, probably at a less vigorous pace, and led not by speculative tech stocks but by higher-quality companies and this year's laggards, especially energy companies. Meanwhile, many bulls and bears also feel that outside an event such as a major terrorist attack, inflation may loom as the biggest threat to the market and the economy -- but most feel it will be kept in check, for this year at least.

"This was a year of superfast growth in supercrappy companies," said Robert Smith, manager of the ( PRGFX) T. Rowe Price Growth Stock fund. "For 2004, expect a more normal market in a very strong economy -- think of a return in the 8% to 10%-12% range. The risk is more likely the fear of inflation and higher interest rates than earnings."

The year 2003 was indeed a great year for all participants in the U.S. stock market, except perhaps the short-sellers. Virtually any long strategy worked. If you felt nostalgic for the halcyon days of 1999, you could have purchased the S&P 500's Internet software and services components and posted a 162.1% gain. If you wanted to ride the housing boom, homebuilders' stocks netted a 96.9% climb. A bet on staid farm-machinery and construction stocks returned 57.9%. Or if you wanted to stash your money in gold stocks, you would have been rewarded with a 70.8% return.

While the debate over the "why" behind 2003's market may seem academic, it holds important clues about the market's course for 2004 and beyond. If the bulls are right, the strong economic recovery evidenced in the latest GDP figures and the robust earnings recovery should put the market on a smooth course. If the bears are right, the stimulus policies may keep the party going for much of the 2004 election year, but spell big trouble in 2005 and beyond.

"We've seen the most stimulative policies than any government has ever tried to do -- 13 interest-rate cuts from the Federal Reserve, two massive tax cuts and the federal budget surplus going from a surplus to a $500 billion deficit," said Ray Devoe, author of the Devoe Report newsletter. "I'm less bearish than I've been for three years, but I'm not exactly bullish," said Devoe, who expects the Dow to remain in a trading range of 9000 "plus or minus 15%."

Thanks in part to the stimulus efforts of the Fed and the Bush administration, the economy and corporate earnings showed strength not seen since the late 1990s. Meanwhile, the stock market rallied as many predicted, but the leadership of that rally caught many by surprise.

Of the 27 S&P 500 components to post gains of 100% or more through Dec. 8, 15 were tech stocks -- among them Avaya ( AV) (335% gain), PMC-Sierra ( PMCS) (218% gain), Yahoo! ( YHOO) (154% gain) and Sanmina ( SANM) (up 145%). Few expect the richly valued tech sector to lead in 2004.

"One of the things that surprised me this year was the market's leadership: It was lower-quality, nondividend-paying stocks," said ( EHSTX) Eaton Vance Large Cap Value manager Michael Mach, who forecast that 2003 would be a strong year. "Maybe investors sensed the opportunity to buy beaten-down stocks, but we're starting to see a move into higher-quality names."

Fred Hickey, editor of the High-Tech Strategist newsletter in Nashua, N.H., agreed that the "stunning surprise" of this year was the outside performance of the most speculative tech companies. "One minute nanotech was hot, then China dot-coms, then semiconductors -- this looks like the bubble reinflated," he said.

While tech's gaudy returns may have grabbed the headlines, the rally has been remarkably broad-based. The S&P 500's Web site lists the year-to-date performance of 10 sectors and 114 subsectors according to the Global Industry Classification Standard, or GICS. Of the 114 subsectors, only five had negative year-to-date returns through Dec. 5 -- only one of which, photographic products, featured a decline greater than 10%. Meanwhile, the top five subsectors had returns in excess of 90%.

In June, TheStreet.com discussed why the latest rally was different from previous bear-market rallies, and why it may continue. At that time, the key to the rally's sustainability was seeing the market's prediction for a recovery turn up in economic data and earnings.

By and large, the earnings recovery has materialized. In the third quarter of 2003, 64% of S&P 500 companies posted earnings that beat expectations, up from the long-term average of 58%. And early signals from the fourth quarter suggest the earnings recovery will continue apace. Of the fourth-quarter preannouncements through Dec. 8, 35% of companies raised guidance -- typically during "earnings warnings" season, only 21% of preannouncements raise guidance, according to Thomson First Call's Gint Rimas.

Meanwhile, the economy has revived as well, as evidenced by the 8.2% rise in the GDP during the third quarter. While Devoe notes that about 2.5 percentage points of that increase was due to tax cuts and low-financing incentives by automakers, many expect the impressive growth to continue.

"We may not see China-like GDP growth as we did in the third quarter, but we anticipate real GDP growth of 4% in 2004," said Bruce Wilcox, chairman of New York investment firm Cumberland Associates.

Market watchers were mixed about whether the recovery would remain a "jobless" recovery. "I think the employment picture gets a lot better -- in every other recovery in history, we see employment lag at first," said James Altucher, a partner at hedge fund Subway Capital and a contributor to Street Insight, TheStreet.com's sibling publication. Altucher said the increase in average hours worked signals that "employers are trying to squeeze as much as possible out of their employees before hiring more. The hiring decisions come next, and the economy follows." Eaton Vance's Mach and others anticipate renewed hiring activity as well.

Anirvan Banerji, director of research at the Economic Cycle Research Institute, believes the U.S. economy will see strong job creation for the rest of the year and in 2004, but "will continue to see a loss of manufacturing jobs next year." Banerji said the loss in manufacturing jobs is part of a dynamic shift toward cheaper labor overseas that won't be reversed by the economic recovery. Nonetheless, he doesn't believe this employment trend clouds the near-term economic outlook. "We will continue to see a robust economy for at least the next few quarters," said Banerji, noting that a negative economic outcome such as a new recession is "highly unlikely for the foreseeable future."

In other words: At long last, the elusive "second-half recovery" has finally come to fruition this year. According to Banerji, the big question for the market in 2004 is: Have expectations gotten ahead of reality?

What 2004 Holds

Even the bulls recognize that the rare confluence of factors that 2003 offered -- low expectations, more reasonable market valuations, easy year-over-year earnings comparisons, negligible inflation, near-zero interest rates and a major fiscal stimulus policy -- are no longer with us for the coming year.

T. Rowe Price's Smith points to two factors that make 2004 look somewhat less glamorous than this year. First, 2003 featured an improving economy with flattish interest rates. Further economic improvement will almost certainly include at least slightly higher interest rates, Smith said. The second factor is an imprecise measure that might be called the expectations gap. "If you believe somewhat in the equation that satisfaction equals reality minus expectation, the gap was quite wide this year. Next year, it's almost impossible for the gap to be that great," Smith said.

Meanwhile, new worries lurk to tamp down expectations, including an almost inevitable rise in interest rates and inflation, the specter of a much weaker dollar and overstretched valuations among many of 2003's leaders.

Many think Federal Reserve Chairman Alan Greenspan will keep interest rates low -- both to keep the economic recovery on course and to avoid having rising rates become a political issue during the 2004 election. However, given that the market is predictive by nature, concerns about rising interest rates and inflation could put a lid on the market's strength. While several money managers anticipate the stock market in 2004 will rise in the high single digits to the low teens, they expect leadership will shift away from this year's highfliers and in to some of the higher-quality fare that lagged a bit in 2003.

"I think there's a very significant rotation in the marketplace right now," said Cumberland's Wilcox, who expects the S&P 500 could end 2004 at 1250, up about 17% from current levels. The rotation involves a movement away from the more speculative tech fare that has already doubled or tripled over the past year and into quality stocks and sectors, especially energy companies. "Most managers are asking, 'Why do I still own XYZ tech company at a valuation of 200 times earnings?' I'm very excited about energy and exploration, which has been a laggard."

Among Wilcox's favorite sector bets: Hanover Compressor ( HC), Spinnaker Exploration ( SKE) and Dynegy ( DYN).

In late 2002, Wilcox predicted the S&P 500 would end 2003 at 1100 -- a call far more bullish than many peers that ended up close to the mark. Wilcox's prediction for 2004 is based on expectations for real GDP growth of 4% and operating earnings in the S&P 500 of high $60s to low $70s per share. Wilcox acknowledges several factors may trip up his sanguine outlook. His "worry case" includes geopolitical risk, an unstable currency policy, a presidential election and inflation -- "We've got the seeds in place for meaningful inflation," he said, which the market may predict before it actually arrives.

"Thanks to new tax laws, we expect dividends are going to increase by about 10% next year and envision corporate earnings up 8% to 9% -- that would support stock price gains in the same 8% to 10% area," said Eaton Vance's Mach. "There will be parts of the market that do better and some that do worse."

Like Wilcox, Mach and others are turning their attention to the energy sector. As Merrill Lynch's Chief Quantitative Strategist Rich Bernstein noted recently, the sector has posted spectacular earnings, up 91% for the third quarter, but the stocks have lagged this year -- up only 11.3% through Dec. 5.

While energy was mentioned by Wilcox, Mach, Devoe and others as a smart bet for 2004, the unifying theme among bulls was a return to quality. T. Rowe Price's Smith cites companies such as AIG ( AIG), Citigroup ( C) and UnitedHealth ( UNH) -- "companies the market is now pricing at a discount" -- as strong performers for 2004.

While Smith expects many of 2003's go-go tech stocks may wither, that doesn't mean the Nasdaq Composite will collapse. "A lot of those highfliers might fall to earth, but if Microsoft ( MSFT), which has been flat this year, gains 25% next year, it will all even out." Microsoft is Smith's second-largest holding.

The bears, meanwhile, cite a laundry list of potential problems on the horizon -- soaring consumer and federal debt, a Federal Reserve that is almost out of stimulus ammunition, concerns about the negative implications of a weaker dollar. However, they also recognize the validity of the old adage: You can't fight the Fed. "This won't last -- secular bear-market rallies just don't last that long -- but the Fed continues to print money, so the market is up," said Hickey of the High-Tech Strategist newsletter. "It's all temporary stimulus -- tax rebates, 1% interest rates, massive increases in the money supply."

Hickey frets that while tech stocks aren't as expensive as they were in 1999, the overall market is. And if the tech sector collapses, the market's rise in 2003 doesn't allow many places to hide. Likewise, Devoe cautions that liquidity-driven rallies don't stand up to stress tests exceptionally well, saying "liquidity is a coward at the first sign of danger."

In the meantime, many say the biggest potential danger for 2004 is inflation -- a far cry from the days of deflation a little more than a year ago. Banerji, whose firm correctly predicted the recession of 2000 and the recovery, said the "inflation outlook is relatively benign for now," adding, "the day of reckoning is not yet upon us."

1. Sound, Fury but No Inflation
2. Market Rally Still Has Legs
3. Asset Allocation Done Right
4. The Five Biggest Scandals of 2003

More from Personal Finance

All 2018 Graduates Must Watch Jim Cramer's Bucknell Commencement Speech

All 2018 Graduates Must Watch Jim Cramer's Bucknell Commencement Speech

The Best Investment Advice? Stay Diversified

The Best Investment Advice? Stay Diversified

Use This Simple Investing Strategy to Stay Ahead in a Rollercoaster Stock Market

Use This Simple Investing Strategy to Stay Ahead in a Rollercoaster Stock Market

5 Most Ridiculous Royal Wedding Memorabilia Items

5 Most Ridiculous Royal Wedding Memorabilia Items

7 Ways Your Financial Adviser Should Help You Survive Rising Interest Rates

7 Ways Your Financial Adviser Should Help You Survive Rising Interest Rates