Fund traders see the stock market poised for another year of positive returns in 2005, but expect weakness in the dollar and a dropoff in corporate earnings to limit its upside potential.

Fueled by strong profits and a post-election confidence boost, stocks made a late surge to close out 2004 with some decent gains as fears over inflation, higher oil prices and a tightening of U.S. monetary policy abated.

The S&P 500 rose nearly 9% to finish the year at 1211.92, and the Nasdaq Composite rose 8.6% to 2175. Meanwhile, the Dow Jones Industrial Average eked out a modest 3.2% gain last year to finish at 10,783 due largely to weakness from drug companies Merck and Pfizer, whose painkillers were linked to heart problems.

The average domestic equity mutual fund posted an 11.5% return last year, according to fund tracking firm Lipper of New York. Within that universe, real estate funds topped the charts with a 32% return, while natural resources funds posted a 29% return. Overseas, Latin America funds turned in a stellar performance, netting a 38% pop.

Lacking Punch

"We had a nice recovery from the profit trough this past year," said David Briggs, head of stock trading at Federated Investors in Pittsburgh. "But 2005 is not going to be so good." While Briggs sees rougher terrain ahead, he believes that 8% earnings growth is still achievable.

After five consecutive years of value stocks outperforming growth stocks, Briggs expects that trend to shift slightly back to the growth side. In terms of market capitalization, small-caps have had a good year and are a little overextended from a valuation standpoint. But the large-percentage gainers are still going to come from the small- and mid-cap area, he said. "It will be tough rooting them out, though," he added.

The dollar will continue to weaken, he predicted, a scenario that will start to drain the "punch bowl" the U.S. economy has enjoyed the past few years. His biggest fear is a dramatic change in currency, an event that ultimately led to the crash of 1987. In that type of scenario, the Fed would be forced to raise interest rates sharply in order to attract foreign capital, which would be very disruptive for stocks, Briggs said.

Trying Tai Chi

Given the strong economic growth in Asia and South America, the U.S. economy is more likely to grow at a slower pace, particularly due to a lack of fiscal stimulus. With that punch bowl being taken away, the U.S. is going to have to behave more like a global citizen, in that respect. "Fundamentals are starting to erode, so I don't think animal-spirited bullishness is appropriate," Briggs said. "Maybe a cautious tai chi stance is what you should be in for the turn of the year." Still, he anticipates that the S&P will eclipse the 1300 level in '05.

Briggs expects commodity exposure to remain "real," with energy, utilities and industrial materials continuing to do well as the number of middle-class families expands globally. Companies that can demonstrate healthy organic growth through some proprietary product or some sort of theme such as alternative energy or homeland defense will also draw a lot of capital, he says.

Small-Cap Steam

Bob O'Brien, head of trading at Evergreen Investments in Boston, said the trend of small-cap outperforming large-cap will continue unless the inflationary impact becomes too great. In the near-term, the geopolitical situation figures to play a significant role as the elections in Iraq approach. "Ultimately, earnings are what will determine the strength of the market," he said. Among sectors, he sees value in the technology and biotech sectors, which have taken their lumps this past year. O'Brien pegs the S&P at 1300 by year's end.

"Believing in the stock market for another year is probably the highest probability move you can make," said Bob Morris, chief investment officer at Lord Abbett, based in Jersey City, N.J. "It hasn't expressed its full potential yet." He expects corporate profits to be up mid- to high-single digits in 2005 and that the market should reflect that, assuming that interest rates don't spike. Morris notes that a weakening dollar should factor into an investor's calculus when putting cash to work by investing in styles that favor lower dollar companies as opposed to stronger dollar companies.

Managing Expectations

According to a recent survey conducted by Merrill Lynch of New York, nearly half of global fund managers expect the prospects for corporate profits to deteriorate over the next 12 months. Thirty-seven percent favor a modest improvement while another 12% think the global profit outlook will remain unchanged. The consensus among the participating fund managers was for 6.2% earnings growth in 2005.

Fund managers also remain concerned about inflation, the survey noted, as a net 60% believe that global core inflation will be higher at the end of next year. Given that sentiment, it is no surprise that investors believe interest rates are on the rise. Although inflationary concerns were a recurring theme last year, they seem to have shifted away from worries about higher oil prices to concerns over unit labor costs.

Kevin Divney, a managing director and senior portfolio manager at Putnam Investments of Boston, said economic prospects look promising for 2005 with capital expenditures hitting a normalized level, the industrial side of the economy booming and consumer confidence at a high level. While he concedes that earnings will decelerate at the aggregate level, he points out that it is reflective of a couple of very large companies dominating an index, such as Microsoft and Pfizer. It is often difficult to grow at a fast clip when a company is that large.

Divney is placing his bets on high single-digit to low double-digit returns for the market this year. He likes the software industry right now because the fundamentals look "fantastic" and expects industrials and materials to continue to do well with transportation benefiting from their success. Companies that partner with the demands of a company like Wal-Mart also present some opportunities, he said.

Barring a collapse of the greenback, the economy is likely to continue growing at a measured pace and that should support share prices in 2005. "I don't see a lot that suggests it's going to be a terrible year in which we're going to be crashing off the rocks of despair," Morris said. "We sort of have to muddle through."

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