Stock investors will have to adjust to reality in the new year.
NEW YORK (AP) -- It's time for stock investors to lower their expectations.
Peering ahead to 2005, Wall Street observers see slower growth as the economy heads into its fourth year of recovery. What's less clear is how investors will react to market returns more in line with historical norms.
One factor likely to work in the market's favor in the coming year is there will be less uncertainty than in 2004, said Sung Won Sohn, chief economist at Wells Fargo in Minneapolis. With the presidential election decided, terrorism concerns diminishing and the possibility of lower energy prices, investors may become more confident.
"To some extent in 2004, especially during the first half ... it was like being in an unlit room," Sohn said. "Investors kind of froze. They didn't want to do anything. They didn't want to hurt themselves."
But investors who've stuck to the sidelines until now may find themselves entering the market at a challenging time. To generate returns similar to the ones enjoyed in recent years, people may be tempted to try riskier investments in 2005. Given where we are in the economic cycle, however, they'd be wise to resist taking too many chances, Sohn said.
"The mantra in 2005 should be caution," Sohn said. "Stay in the stock market, but be on the defensive side, because the economic recovery is almost four years old."
Some of the most compelling problems facing the markets in 2004 were external, such as tension overseas. The biggest concerns in 2005 are likely to be domestic -- decelerating corporate profits and the Federal Reserve's continued tightening of interest rates.
The federal funds rate -- the interest banks charge each other on overnight loans -- currently stands at 2.25 percent. Next year, economists expect the Fed's Open Market Committee to gradually increase this key borrowing rate to at least 3 percent, if not to 3.5 percent.
While the Fed has done a good job telegraphing its monetary policy, and a sharp spike in rates is unlikely, "a rising rate is never a friend to the stock market," Sohn said, because it boosts corporate borrowing costs. That, combined with generally slower earnings, will create enough headwind to keep stock returns at a fairly modest level.
The slowdown in earnings may feel "like going from 85 miles per hour to 55 miles per hour," Sohn said; profits are likely to fall back to safer, more sustainable levels, but the market may not appreciate shifting out of the fast lane.
But it shouldn't come as a surprise: The bull market is three years old and its "knees are creaking a little bit," said Alfred E. Goldman, chief market strategist with A.G. Edwards & amp; Sons Inc. in St. Louis. After 17 months of robust returns, a slowdown is inevitable, he said. How investors perceive it remains a key question.
"Will people look at this as a glass-half-full or half-empty scenario? Will they say, 'Isn't that wonderful, the economy is sustaining its upward swing,' or will they get grouchy?" Goldman asked. "That will all depend on the mood of investors."
Investors may try to chase yield through bonds and international issues, which is fine as long as they do it with caution, as part of a diversified strategy, analysts said. Spreading out risk is going to be critical, said Arnie Holzer, senior investment strategist for asset allocation at Deutsche Asset Management.
"For the smart investor, being well-diversified, in terms of owning some international, some emerging markets, some bonds, some international bonds, is going to be very positive for next year's portfolio returns," Holzer said.
For beginning investors, or individuals who aren't sure where to put their money in 2005, Holzer suggested global asset allocation funds, which are "funds of funds" that offer broad exposure to a wide variety of stocks and bonds, both domestic and overseas. If you go this route, look for one with a moderate to aggressive bent; this strategy will favor equities, which are likely to provide better returns.
Despite the fact that stocks are expected to do better than fixed income, it would be a mistake to build a portfolio without bonds, Holzer warned.
"Oil prices, Iran, Iraq ... there are tensions that could spark volatility. We have a world with geopolitical stress. That warrants holding bonds," Holzer said. "But the basic environment for next year is one in which we see earnings growth stabilizing at a more normal, historically defensible level. ... The general environment looks very positive for equities."