Econ Edge: The Economic Week

Dec. 27, 2004 — -- This week's intra-holiday sessions will likely be quiet as many people take a break before the New Year.

There are a few economic reports of interest. Most notable is the November existing home sales numbers to be released on Wednesday. It's the last significant national economic report of 2004.

We invited Sam Stovall, Standard & Poor's chief investment strategist, to take a look back at the year on Wall Street.

ABC: All the major indices look like they'll end the year in positive territory. What was the most important issue that drove the markets this year?

Stovall: I think the election was the most important factor. Early in the year, the front-runner -- Howard Dean -- appeared flamboyant, but not a serious threat to the president's re-election effort. (Since Wall Street favors the pro-business candidate, President Bush was Wall Street's favorite.)

As a result, the market hit a high just prior to the beginning of the primary season. Yet when John Kerry -- a more credible threat to the president's re-election efforts -- became the front-runner, the market began to get concerned. Of course, oil prices and the threat of an earlier-than-expected start to the Fed's rate-tightening program contributed to the market's jitters.

ABC:What was the most surprising moment on Wall Street during 2004?

Stovall: The muted response to the Fed's rate-tightening program was probably the biggest surprise for me.

In 1994, stocks tumbled nearly 10 percent five months after the Fed started raising rates in early February, while bonds experienced their worst decline in decades. Yet this time -- possibly because of the Fed's superb job of telegraphing their actions, combined with the indication that the rate-tightening period would occur over an 18- to 24-month period versus 13 months in 1994-95 -- stocks pretty much shrugged off higher interest rates.

ABC:What is your prediction for market performance during 2005?

Stovall: We think 2005 will be a good year, but not a great year. One reason is the aging of the current bull market.

This upward move began when the S&P 500 bottomed out in October 2002. That puts us well into the third year of this advance. Since 1942, the average advance in the third year of a bull market has been only 3 percent.

What's more, of the 10 previous bull markets that celebrated a second anniversary, six were either flat or down by the end of what would have been their third year. And even though bull markets have lasted an average 4½ years since World War II, three times a new bear market began even before the third- year bull had come to a close.

We see the S&P 500 ending 2005 at 1,300, an 8.3 percent gain from the 1,200 we project for year-end 2004. Add in a 1.7 percent dividend yield, and our projected total return is just slightly below the 11.2 percent annual average posted by the "500" since the end of 1969.

Corporate profits should hit a new record again next year. We see an earnings increase for the S&P 500 of 10 percent. Although that is less than half the spectacular 23 percent earnings advance that we estimate for 2004, it remains substantial, in our view, and constitutes a positive background for equities. The S&P 500 is currently trading at a P/E of 21, based on trailing 12-month "as reported" earnings, which is very close to its 20-year average multiple of 22. In addition the current multiple is 54 percent below the 46 P/E seen in 2001.