Market forecasts for next year more modest

NEW YORK -- Investors celebrated the long-awaited return of the bull market in 2003, snapping up shares after three years of bitter declines. But 2004 arrives with a warning for an increasingly exuberant Wall Street: The best of the gains is over.

With stocks advancing since March on hopes for a strong economic recovery, the three main gauges are trading at their highest levels in nearly two years.

Stiff challenges for the coming year, however, include the risk of rising interest rates, a widening mutual fund probe and investor overconfidence.

"In 2004, the first issue is for individual investors to get their expectations in line," said Robert Froehlich, chief investment strategist for Deutsche Asset Management in Chicago. "When we started this year, no one thought anything positive was going to happen."

"Now that the Nasdaq is up 50 percent, many might believe we'll get 50 percent gains from here to eternity," he said. "But 2004 won't be as strong."

Forecasts for the new year are certainly more modest, ranging from a flat performance to a 15 percent advance. At least one analyst believes that after a decent rise in the first half of 2004, the Dow Jones industrials will slide from over 10,000 back to 8,000.

In 2003, the three main gauges have posted solid double-digit gains, with the Nasdaq reaching 2,000 -- last seen Jan. 15, 2002 -- and the Dow crossing the 10,000 milestone, the first time since May 31, 2002.

'Juicing' the economy

Analysts cite several risks to the market in 2004, both fundamental and technical:

With short-term interest rates at a 45-year low, the Federal Reserve faces increasing pressure to raise rates to stave off inflation in a recovering economy. Indeed, at its Dec. 9 meeting, the Fed issued upbeat comments about the economy that some analysts believed signaled a possible rate hike by mid-2004. Higher rates could dampen consumer and business spending, which are critical to a solid rebound.

A presidential election year typically sees more modest stock gains, of about 7.3 percent, compared to a robust 16.7 percent in the third year of a presidential term, according to the Stock Trader's Almanac. Experts attribute that to political uncertainty and a "juicing" of the economy by incumbents in the third year that loses effect over time.

State and federal regulators continue to widen their probe into shady trading practices in the mutual fund industry. While individual investors have largely stayed put in funds, more revelations of wrongdoing might rattle confidence and spark selling.

In general the value of stocks is a bit high relative to companies' profits, particularly in the tech sector. Many analysts believe stocks are due for a pullback of about 10 percent or more.

"It's pretty dangerous when investor consensus gets very bullish at the same time valuations are getting stretched and risks are high," said Bernie Schaeffer, chairman of Schaeffer's Investment Research. He predicts the Dow will be at 8,000 by the end of 2004.

Still, investors can't help feeling upbeat.

Ted Kennedy, an executive for a franchising company in Ann Arbor, Mich., recently began increasing his shares in health care and consumer cyclicals, which typically do well during an economic recovery.

"There is life after recession," Kennedy said. "The decline that happened during the last bear market was the most significant in my investment lifetime -- I had never seen a drop this sustained. ... Now I'm more optimistic."

That attitude is in sharp contrast to how investors felt when dismal corporate profits, terrorism fears and accounting scandals sent the Dow to a five-year low and the Nasdaq and S&P indexes to six-year lows on Oct. 9, 2002.

That date turned out to mark the end of the bear market which began in 2000 -- the first three-year downturn since Franklin D. Roosevelt was president in 1941 -- as investors came back in 2003, lured by rock-bottom interest rates, a $350 billion tax cut package and optimism after the war in Iraq subsided.

Analysts say the good economic news will continue in 2004, but with investors upbeat, much of the strong data already has been priced into the market. That could make stocks resistant to a significant advance and vulnerable to declines should the data unexpectedly disappoint.

In addition, the market historically has seen short-term "cyclical" bull markets happen within a longer-term "secular" bear market. Some analysts believe a secular bear market began when the tech bubble burst in 2000; if so, that could mean fleeting gains in 2004.

"With rates rising, more of the surprises in 2004 will be on the negative side than positive," cautions Tim Hayes, global stock strategist at Ned Davis Research in Venice, Fla. "The market has now gone up for more than a year. It wouldn't be unusual to see a stiff correction."