Will the Rally Continue This Year?
Get Both a Bullish and Bearish Perspective
Published: February 04, 2005
By Diana Brown
After struggling for much of the year, the stock market ended 2004 with a bang, with the S&P 500® hitting highs not seen in more than three years.
Now that we're a month into 2005, and the first bull market of the 21st century heads into its third year, many investors may be wondering: Can this growth continue in 2005? Or are we in for a fall? Or something in between?
To get a balanced perspective, we talked with outspoken bull Jeremy J. Siegel of the University of Pennsylvania's Wharton School of Business and inveterate bear Robert Shiller of the Yale University School of Management.
Siegel, the Russell E. Palmer Professor of Finance, has written a forthcoming book, The Future for Investors: Why the Tried and the True Triumphs Over the Bold and the New (Crown Business). In the book, he concludes that investors are better off buying stocks of more established companies compared to newer companies, which may have overpriced stocks and inferior returns. In his bestseller, Stocks for the Long Run (McGraw-Hill), Siegel argued in favor of investing in stocks for the long term based on his research dating back to 1802.
Shiller is Yale's Stanley B. Resor Professor of Economics and author of the best-selling book, Irrational Exuberance, published in 2000, which cautioned about the effects of market volatility and the national obsession with stocks. In his latest book, The New Financial Order: Risk in the 21st Century (Princeton University Press), Shiller describes ways to use information technology and advanced financial theory to mitigate financial risks faced by individuals today.
Q: After staying in the doldrums for much of the year, the market bounced back in the fourth quarter of 2004. The S&P 500 hit a three-year high in late December and was up 10.88% for the year. Can investors expect this to continue in 2005?
Siegel: We can't expect the type of gains we had in 2003. We know the Fed is going to continue to raise interest rates. Profits will continue to rise, and the lower dollar is going to bring some export demand. My feeling is that the main level of return on the market is something like 6% after inflation. But from year to year, the potential is there to have tremendous variation in returns.
Shiller: The market is still overpriced, and that fact is a big negative for future returns, but the market will not necessarily do badly in 2005. It is always possible that there will be a repeat of what happened in the last bull market, which ended in early 2000. There was a big boom in tech stocks. People were warned about over-excitement in tech at the time. I think that warning should probably apply today, too. People should be long-term investors, and they should look for long-term value.
Q: The market has done well, despite some negative economic influences, including high oil prices, a weakening dollar, and decelerating earnings growth. Why the resiliency? And what impact will these influences have going forward in 2005?
Siegel: I don't consider a weakening dollar negative for stocks. I think that could be positive for companies, especially those involved in exporting. The travel industry in the U.S. is thrilled by the number of Europeans coming over who think the U.S. is a bargain basement now. Firms that sell abroad and then translate those euros and yen back into dollars are showing a very good profit gain. So dollar decline is not really a negative. And although earning growth is slowing, it's still increasing. That's key. That is the reason the market has held up well.
Shiller: The oil price increases in the fall of 2004 were extraordinary. They were putting us at prices similar to those of the first oil crisis in the mid-1970s, and yet it had relatively little impact. That was surprising. In the past, oil price increases hurt the stock market and the overall economy much more than they did this time. Consumers have bought the story that oil is less important in the economy than it used to be. And it is less important. We are less reliant on oil than in the past. I think, though, that rising oil prices remain a threat. They're still high. I'm worried about another speculative upsurge in oil. That could hurt the stock market and the economy.
Q: What are the bullish signs you see in the market as 2005 gets underway?
Siegel: The fact that oil is down is bullish. The lower dollar is bullish for stocks. We're going to get some merger activity from abroad. In my new book, I talk about how important China, India, and the developing countries are going to be. If the dollar continues to decline, U.S. stocks are going to look very cheap to foreign companies that want synergy and want to merge. We have the presidential election out of the way, so companies can plan ahead. There's some stability looking ahead that is going to be comforting to the market.
Shiller: George W. Bush has been reelected. He's obviously pro-market, and he's talking about creating Social Security individual investment accounts so people would have the option of investing in the stock market. That kind of talk may be boosting the market.
Q: What are the bearish signs?
Siegel: Rising interest rates are a threat in the market. I also worry about instability in the Middle East. I believe the stock market and the housing market can survive another percentage point increase by the Fed. If it goes much higher than that, particularly on the bond rate, that's really going to slow down the housing market, which is already very highly priced.
Shiller: If there is another shock to oil prices, there might be an overreaction in the oil market. That could harm the world economy and stock markets of the world. That's one bearish concern. Another is that we're going through a bubble in home prices in many cities around the world. In 2005 and 2006, we could see declines in home prices, especially if the tightening of the Fed continues. Falling home prices could be a factor that harms confidence in the economy and brings on another slowdown, possibly in the stock market.
Q: What kind of economic impact can investors expect in the aftermath of the Asian tsunami disaster?
Siegel: I believe that the economic impact will be small, except for some insurers and hotel chains. Most of the infrastructure and production facilities of these countries remain intact. Furthermore, I believe foreign aid will revive many local economies who have endured this tremendous human tragedy.
Shiller: The tsunami disaster staggers the imagination in terms of the human loss. But the economic impact of the disaster is still small by world standards. I think that the biggest impact for investors is to remind us to think about low-probability big events. Most of the loss of life came from a human error of being unprepared for such an event, which we all knew was a possibility. The tragedy is a poignant symbol of the human error of assuming that fair days will go on forever, that we can always extrapolate past successes, that 30 years of data of success proves that bad things can't happen. We should all think of our tendency to make such an error in our own investments as well.
Q: How important will it be for investors to diversify internationally in 2005 and beyond?
Siegel: We all should add more international exposure. For the average long-term investor, I recommend they hold about 40% of their stocks in non-U.S. based firms. With the economic growth in Europe and Asia, the United States is going to become a smaller and smaller world economy in the next decade. More capital is going to be produced abroad. It doesn't mean that returns abroad are going to be all that much better, but if you limit yourself to the United States, you're taking on more risk than you need to. International diversification is very important looking forward.
Shiller: I agree that people should diversify internationally. There's a chance that the dollar will move to make foreign investments even better because we still have a huge trade deficit. That's been a signal that the currency will depreciate further, so having our money invested abroad is a great idea.
Q. Given today's rising interest-rate environment, how do bonds look to you in 2005?
Siegel: I don't think 2005 will be a good year for long-term bonds. I think the Fed will continue to raise rates and the economy will be surprisingly strong. Low-grade, or "junk bonds," have done very well, but their margins over government bonds are very small now and they also would be negatively impacted. Stocks should do much better.
Shiller: Bonds should still be part of people's portfolios. People ought to consider municipal bonds because of their tax-advantaged status. I would advise emphasizing relatively shorter maturities, which have less of a risk of capital loss. Moreover, long-term U.S. Treasury inflation-indexed bonds (TIPS), even though their real yield has fallen from around 4% after they were first issued in 1997 to around 2% today, are still a sensible addition to a long-term portfolio, and can substantially reduce its risk.
Q. What kind of asset allocation among stocks, bonds, and cash would you recommend for today's average investor with a long-term investment horizon?
Siegel: The key word here is "long term." In researching my latest book, I found that those companies that grow the fastest are not the best investments. They get overpriced. They attract way too many investors. People tend to over bet the favorite, and, as a result, even though that might be the best horse in the race, it's not a profitable betting strategy. You always have to look at the price. You must look at value. After doing my research, I've definitely tilted more toward value stocks. That said, for an investor with a long-term horizon, I would recommend having at least 75% of his or her portfolio in stocks.
Shiller: I don't give out percentages, but I think the message should be that one should diversify. Real estate has some place in the portfolio, but not too much. I think people should hold some stocks in their portfolios, but they have gotten a bit too optimistic about stocks. Stocks did very well in the 20th century, but we can't guarantee that they'll do that in the future. That was another century. This is a new one. I would say stick with the old adage about diversification, because we don't know what the market is going to do.
Q. How are you positioning your own portfolios for 2005?
Siegel: As I mentioned earlier, I am putting more of my equity money into foreign-based stocks. I would recommend indexing half your equity allocation to the world stock market -- 20% outside the U.S. (say in the EAFE Index) and 30% in the broadest-based U.S. index. I would tilt the other 50% toward high dividend-paying and low P/E stocks, and the pharmaceutical, consumer staples, and energy sectors.
Shiller: My situation is a little unusual, since I am involved in creating a startup company, and am investing in that. So I am less likely to want risky investments for the rest of my portfolio. Everyone is different, and everyone needs to think carefully about how their portfolio meshes with their own risks, and not emulate my or anyone else's portfolio allocations.
(E-mail any questions or comments to Investor's Weekly at Investors.Weekly@fmr.com.)
Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk. Asset allocation does not ensure a profit or guarantee against loss. Generally, among asset classes stocks are more volatile than bonds or short-term instruments.
Past performance is no guarantee of future results.
Unless otherwise noted, the opinions of the authors provided are not necessarily those of Fidelity Investments. Views and opinions are subject to change at any time based on market and other conditions. These materials are provided for informational purposes only.
The S&P 500® Index is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. It is an unmanaged index of the common stock prices of 500 widely held U.S. stocks that includes the reinvestment of dividends.
The EAFE® Index (Morgan Stanley Capital International Europe, Australasia, Far East Index) is an unmanaged index of over 1,000 foreign common stock prices and includes the reinvestment of dividends.
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