Economy Slows, But Markets Pick Up in 2005 Says Merrill's Doll

For the coming year, Doll again made ten predictions for how the economy and stock market will fare in the coming year, saying that “the economy will be just fine this year, but not as good as it was…and the market will reflect that.”   His ten predictions for the year ahead:

• Led by a slowdown in consumer spending, US real GDP growth slows to less than 3.5% in 2005.

However, even with slowdowns across consumer and capital spending as well as in residential investment, Doll says that an increase in GDP between 3% and 3.5% is still good.

• Every major economy in the world slows, but Asia continues to lead and Europe continues to lag.

Global short rates rose 50 basis points between year end 2003 and 2004, Doll reports, but real GDP growth will slow between 2004 and 2005.

• Profits advance less than the 10% consensus forecast as surprises are no longer positive due to slowing demand and some margin pressure.

“Profit margins increased three years in a row,” says Doll, “and there is only one instance of four years of growth since World War II; this will not be year we see that pattern again.” Doll cites a demand slowdown, productivity growth slowing, unit labor cost increases, and other cost pressures as the reason for the predicted shortfall against the consensus.

• Interest rates continue to move higher as “the bear flattener” takes Fed funds to 3.5% and ten-year Treasury yields to 5%.

Doll expects that, as a result of the absence of deflation, the lower dollar, commodity increases, and the advancement in the economic cycle, the Federal Reserve will continue its rate increases to normalize its rate to reach a 3.5% federal funds rate by year’s end. However, Doll cautions that the Fed could move more quickly if inflation spikes, the dollar tumbles, or foreign investors start to demand a higher yield on the U.S. securities they’ve been investing in.

• US stocks struggle, but outperform bonds and cash for the third year in a row.

The stock market will most likely be up again in 2005, and will also outperform both cash and bonds for the third year in a row, but will have very modest gains as it will be “muddling through,” Doll said. Based on past market trends, there is also some probability that stocks will have a down year, Doll added.

• The average stock underperforms the averages for the first time since 1999 as large-cap and high-quality outperform small-cap and low-quality.

Stocks will break their streak this year, Doll predicted, citing that the past five years have seen that the average stock in a given index has outperformed that index, largely, he thinks because of small-cap performance; something he sees changing in 2005.

• Strong balance sheets and high excess cash flow generation creates an increase in M&A activity along with dividend increases, stock buy-backs and capital spending.

Doll explains that American corporations have a record amount of cash on hand right now, at an estimated more than $1 trillion, and are struggling to grow organically, which will lead to increased merger and acquisition activity (especially cross border, because of the weak dollar), most likely emphasized in the healthcare, technology and financial services sectors.

• Commodities perform well again with oil prices averaging above $40 per barrel.

Contrary to some popular opinion, Doll does not predict a large fall in oil because OPEC's spare capacity is close to zero currently, which will not lead oil prices resting at 2002 or 2003 levels, but rather similar to those seen during 2004.

• Optimism from Washington regarding the passing of market-friendly legislation gives way to intra- and inter-party bickering.

Doll, when looking at the current agenda, sees "very bold and big" plans that he thinks will be difficult to get through. The agenda includes such things as: making the tax cuts permanent; reforming Social Security; simplifying the tax code; limiting federal spending; and fighting more of the War on Terror.

• While still significant structural problems, the US federal budget deficit, trade deficit and current-account deficit all improve for the first time in 10 years.

Although there are still structural problems with the US savings rate, federal spending, the current account versus the federal deficit and federal budget, and the manufacturing pay gap, Doll says that against huge debt levels, total household net worth is growing.

Overall, Doll predicts that stocks will go up for the third straight year, but possibly barely or not at all.   In the long term, Doll continues to forecast what he deems an 8/5/2 world: stocks will average 8%, bonds 5% and cash 2%. These figures are actually very close to the final figures in 2004 in which the Dow Jones Industrial Average had a 2004 return of 5.3%, the S&P 500 finished the year with a 10.9% return and the NASDAQ returned 9.2%; bonds averaged 4.8%; and cash came out with 1.3% returns.

As for track records, Doll's 2004 predictions fared well, ending the year with seven coming true, two being proved incorrect, and one yet to be determined:

1. U.S.real growth will reach 4% for the first time in five years. (Correct)
2. The American consumer will pass the growth baton to the rest of the U.S. and the world economy. (Correct)
3. Earnings growth, led by revenue growth, will again exceed expectations. (Correct)
4. The Fed will remain accommodative while nonetheless doubling its rate. (Correct)
5. Strong economic growth, some pricing power and a declining dollar will drive the yield on the 10-year Treasury note above 5%. (Incorrect)
6. The U.S. stock market will again outperform cash and bonds but fail to match 2003 returns. (Correct)
7. A transition will take place from low-quality, low-cap and high-beta stocks to higher-quality, higher-cap and lower-beta stocks. (Incorrect)
8. Oil, gold and other commodities will continue to climb in dollar terms. (Correct)
9. The Republicans will convincingly win the 2004 election. (Correct)
10. High debt levels and other structural imbalances will combine with rising rates and high absolute valuations to cause a cyclical bull market peak in late 2004 or early 2005. (Unknown)