Given the shocking developments that have come to the fore in the mutual fund scandal this past year, it is easy to lose sight of the fact that the stock market is on a tear.

Investors would be remiss to ignore the nascent recovery that has emerged on Wall Street. A successful military campaign in Iraq, a low-interest rate environment and encouraging economic data have catapulted stocks back from the Styxian depths of a three-year bear market.

Indeed, the major averages crossed psychologically important levels in late 2003. Overall, the Dow Jones Industrial Average soared 28% to 10,450 as of Monday Dec. 29, marking its highest close in 21 months. The S&P 500 rose 28.2 % to 1109, a 20-month high; and the Nasdaq gained 28.4% to 2006, a 23-month high. The economy has also made significant strides as evidenced by an 8.2% pop in the nation's gross domestic product in the third quarter. To boot, unemployment is falling, capacity utilization is increasing, housing starts are strong and consumer confidence is gathering steam.

The average domestic equity mutual fund is sporting a 31.7% return, according to New York-based fund tracker Lipper. Within that universe, technology funds have topped the charts with a 56% return year-to-date. Overseas, conditions have been even better as international equity, emerging markets, Latin America, China and gold funds have each generated an average return above 50% for the year.

That being said, the question remains whether this momentous rally is sustainable or not?

There are varying viewpoints on the topic among industry pundits, a debate that hinges upon what exactly drove the run-up in stocks in the first place. The prevailing sentiment among bullish investors is that strengthening economic conditions and a comeback for corporate earnings have served as the catalyst. In the third quarter, 64% of S&P 500 companies posted earnings that topped analysts' expectations, ahead of a historical average of 58%.

Show Me the Earnings

Tom Gunderson, lead manager of the $1.2 billion First American Large-Cap Growth Opportunity Fund for U.S. Bancorp Asset Management, is optimistic that the market will continue to move higher this year but does not expect it to keep pace with 2003.

"We've seen a nice rebound in the market with an improved operating outlook and metrics within companies and the economy - a huge improvement. To see another huge improvement from the current level of operating performance of the economy, I don't think is realistic," he said. "Typically, the biggest moves are off the bottom." Still, he noted that it wouldn't be a surprise if stocks move up with earnings this year to produce an 11% improvement on the S&P 500.

It's now more of a "show me" market, Gunderson said, whereas last year was more about making sure you didn't miss the rally. Essentially, he wants to see the earnings come through to justify stock valuations. Based on that precept, it stands to reason then that blue-chip laggards like Gillette and DuPont would fare well in that type of market because they have a proven track record in terms of earnings and business model yet they didn't participate in the rally like many small-cap and technology stocks.

As of last week, stocks were trading at a price-to-earnings multiple of 18, according to Standard & Poor's. An area where Gunderson sees real value this year is in pharmacy benefit managers such as Express Scripts and Caremark. Medical equipment makers, particularly those related to heart procedures, are another sector he expects to take off in 2004.

According to a survey conducted by Merrill Lynch of New York, more than three-quarters of global fund managers expect the prospects for corporate profits to improve over the next 12 months. The consensus for EPS growth among the respondents was a shade under 11%. A majority of the fund managers said that China will be a positive influence for the global economy serving as one of the best sources of growth in 2004.

"While international markets have outperformed this year, we still think there's more to come," said Ron Holt, managing director of Hansberger Global Investors and manager of the $163 million Harris Insight International Fund. "We continue to like emerging markets, and the non-Japan developed markets of Asia."

Bears argue that surpassing drastically lowered expectations is not adequate proof that the market is over the hump. Further, the bear camp argues that the rally was merely a function of a lax monetary policy and federal tax cuts that pumped liquidity into the market and not indicative of improving fundamentals.

"The market seems to be ready for a pause as investors [brace] for the next round of earnings releases in January," said Christopher Orndoff, lead strategist of the Payden U.S. Growth Leaders Fund, a small-cap offering that boasts a 33.4% year-to-date return as of Nov. 30, 2003.

"During market pauses, large-cap value generally does better than large-cap growth. For the balance of 2004, however, we believe that large-cap growth will be at the top of the charts since these stocks will exhibit stronger earnings growth, and as the economy gains momentum next year, investors will be attracted to the operating leverage present in large-cap companies," Orndoff said. He believes stocks will outperform bonds by a wide margin in the first nine months of 2004. Orndoff is concerned, however, that aggressive interest rate cutting and tax relief, which were designed to achieve maximum growth for 2004, may be followed by significantly lower growth in 2005, after the presidential election is over.

Perhaps the biggest threat to the stock market this year is inflation. Investors are becoming increasingly convinced that interests rates will rise this year on the heels of the Fed's 13 consecutive rate cuts. Currently, the Fed funds target rate stands at 1%, a 45-year low. Chairman Alan Greenspan continues to believe that an accommodative stance of monetary policy, along with robust underlying growth in productivity, is providing ongoing support for the economy.

"We've seen the lows in interest rates, already on the short end and likely on the long end as well. It's a matter of will they sustain this level, or when they move up which end moves up," Gunderson said.

"We think the Fed will look to raise interest rates by mid-year next year and three times during all of next year," said Margo Cook, head of institutional fixed-income with the Bank of New York. She expects short-term interest rates to rise from 3.5% to 5.5% during 2004.

The underlying theme for 2004 is shaping up to be companies' ability to deliver earnings growth. Strong earnings growth along with increased capital spending will be the proof in the pudding for the skeptics. At the very least, the short-term outlook for stocks is quite rosy and the new year will afford investors plenty of opportunities to take cash off the sidelines.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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