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Yes, it’s thermal pollution time again, the time of year when Wall Street’s prognosticators expel large volumes of hot air. I have been a participant in this annual ritual for several decades now, and actually seem to be getting better at it in recent years. (With age comes wisdom?) But, I did blow it last year with my 2004 interest rate predictions as well as my stronger dollar prediction. I was also too pessimistic with my budget deficit projection, while underestimating the run up in crude oil prices (but, who didn’t?).

Nevertheless, as I state each year: Predictions are for show, while the coming year’s ongoing portfolio shifts are for dough. The real value of our work is in the mid course adjustments made as next year’s conditions warrant. For it is the markets themselves that always seem to provide both unexpected opportunities and unanticipated risks. I should point out the predictions herein are mine and mine alone.

The 2005 U.S. Stock Market

After being resolutely bullish for two years, I am considerably more cautious about 2005. As I write this, the S&P 500 is at the 1200 level, but I suspect the current cyclical bull market’s peak may not be that far away. My current guess is a peak around 1300-1320 in the first quarter of 2005, only about 8%-10% above current levels. My target for the NASDAQ is 2400-2500. Before 2005 is history, I think the S&P 500 may retreat to the 1000 level, with the NASDAQ testing 1700. My guess for year end 2005 is 1075 for the S&P 500 and 2000 for NASDAQ. In duration and magnitude, the performance profile noted above would approximate a typical cyclical bull and bear market progression. The current cyclical bull market is over two years old, up 47% from the October 9, 2002 lows. This about matches the duration and magnitude of the last 21 cyclical bull markets, 1900 to date. Per the historical time clock for economic cycles since WWII, the current economic expansion might be expected to peak late in 2005 and normally the stock market turns down 6-7 months prior to the economic peak.

In addition to the historical cyclical considerations, our 39 stock market valuation factors indicate, on balance, the U.S. stock market is quite overvalued (although certainly not comparable to the radical overvaluations existing in 1999-2000). With 2004 profit margins currently challenging 50 year peaks, 2005 earnings growth may be less than 10%, maybe not enough to support current extended valuations. In addition, the net reading of our comprehensive Major Trend Index has regressed to Neutral territory, but has not yet downshifted to Negative.

In summary, I am cautious and nervous in terms of U.S. stock market prospects in 2005, without even considering an inflation flare up, budget deficits, the dollar, consumer debt, the trade deficit, or terrorists and Iraq.

The 2005 U.S. Economy

GDP growth for the coming year is estimated at 3.3% (inflation adjusted) with growth fading in the second half of the year. Based on our economic time clock, a recession (or hopefully a “soft landing”) may be getting underway late in 2005, but most economists will not recognize it as such. Productivity growth will continue to fade as it always does in a mature expansion. Capital expenditures should continue to increase (corporations have lots of cash) but consumer spending may lag, particularly if interest rates on consumer credit rises significantly. I also expect that the economic benefits of the dollar’s decline will become more obvious. Wage inflation is expected to tick up to about 3% (now 2.4%) and the unemployment rate may drift down to 5% (now 5.4%).

Corporate Earnings In 2005

Along with the consensus, we have been estimating 10% earnings growth for 2005. Our S&P 500 estimates are $65 reported, $73.75 operating, and $61.60 core. Using the NIPA series we have also been estimating 10% growth for 2005. However, Jim Floyd and I are beginning to think our 2005 earnings growth estimates might be too high. Profit margins are currently the highest in 50 years (S&P Industrials and NIPA after tax profits). Can they move even higher in 2005? If not, earnings growth may be no greater than top line growth which is estimated at 6% in 2005, down from 8% in 2004. In addition, it now appears options could become an expense for the last six months of 2005. Considering rising wage costs and interest costs, my guess is aggregate earnings growth in 2005 might be only 6%-7% even with a boost from the dollar’s decline. This is less than the current consensus of 10%. The best 2005 earnings momentum might come from Energy, Materials, and Technology (but I might note that growth expectations for Technology are now being revised downward).

The Dollar In 2005

I think the post-election Bush bear market in the dollar has been overdone, particularly the decline against the euro, now $1.34. (I have very recently shorted euro currency contracts.) Europeans believe Bush is a disaster both in terms of his foreign policy and domestic fiscal policy. This attitude has served to erode European confidence in our dollar and their trust in the stability and underlying strength of our country.

But, when compared to Europe (not Asia), the U.S. has a much stronger economy. In addition, our current fiscal difficulties are certainly no worse than the dominant countries in the EU that first violated, and then discarded, their GDP related deficit disciplines. And, for that matter, Europe’s government sponsored retirement programs are typically in even worse shape than our Social Security. Thus, I think the euro is probably now significantly overvalued relative to the dollar. I expect to see at least a 10% rally in the dollar (against the euro) in the next few months to about $1.20, with further strength developing late in 2005 carrying the rate to $1.16. I also think the dollar will end the year 5%-10% higher against the yen.

In terms of Asia, China remains the wild card. Will they or won’t they delink the Yuan from the dollar? I think this could happen late in 2005. If this happens, the dollar would seem destined to fall against the Yuan and the trade weighted dollar would suffer, even if the dollar was up against the euro, the pound, and the yen. Should this delinking occur, the Yuan would probably be elevated to the benchmark currency for much of the Pacific Rim (A China objective?).