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msnbc.com
updated 1/1/2005 2:45:04 PM ET 2005-01-01T19:45:04

In the end, it was an unexciting finish to a rather unremarkable year for equities. Wall Street closed Friday’s sluggish trading session, the last of 2004, with modest losses, but chalked up a second straight positive year for the stock market.

The Standard & Poor’s 500-stock index was off 1.63 points — or 0.1 percent — at Friday’s close, making for an annual gain of 9 percent for the broad market index, roughly matching analysts’ estimates for the year, but falling far short of the 26 percent gain seen in 2003. The Dow Jones industrial average rose 3 percent in 2004, while the Nasdaq composite index added nearly 9 percent.

Overseas markets also finished 2004 moderately higher, including major European stock indexes in the United Kingdom, Germany and France and Japan’s benchmark Nikkei average, all of which were up between 7 and 8 percent for the year.

Still, some analysts were upbeat about the markets in 2004.

“When you look at it, it’s astounding to get the kind of performance we had this year when you think about the negative effects of the bubble bursting from the ’90s, the various corporate shenanigans we had and the rise in energy prices,” said Joseph Battipaglia, chief investment officer at Ryan Beck. “The year’s been very consistent with what we’ve seen in the second year of an economic recovery, and the growth we’ve seen is pretty good, all things considered.”

Some star performers
Friday’s rather languid trading session on Wall Street capped a year in which U.S. stock indexes seesawed as traders were transfixed by a horde of economic and geopolitical events, including a fiercely-fought U.S. presidential election, increasing violence in Iraq, sluggish job growth and surging oil prices.

However, while the world’s major markets finished the year only moderately higher, there were some commodities-driven star performers.

In the United States, the Russell 2000, an index of small-capitalization U.S. stocks, finished 2004 with a gain of 17 percent and at an all-time high, outperforming large-cap stocks for a sixth straight year. The rally was driven by small-cap commodity stocks, boosted by China’s strong demand for products like oil and steel. Strong commodity demand also boosted Australia’s All Ordinaries stock index, Asia’s star performer in 2004, chalking up an annual gain of 23 percent.

Late pick-up
In fact, if not for a strong rally in the fourth quarter, Wall Street’s performance in 2004 may well have gone down as one of the most lackluster in recent years. Just over two months ago, with the outcome of the presidential election still unknown, the major U.S. stock indices were trading below where they started the year.

The onset of the market’s inertia had coincided with a series of terrorist bombings on commuter trains in Madrid on March 11, which killed nearly 200 people. Adding to the sluggishness mid-year was concern that the Federal Reserve would soon begin moving short-term interest rates up from four-decade lows, and surging crude oil prices, which hit a record high of $55 a barrel in late October, denting company profits and consumers’ wallets.

But days before President Bush claimed victory for a second presidential term in early November the market shook off its inactivity and moved steadily higher for the remainder of the year, boosted by declining oil prices and an end to the uncertainty over the outcome of the election. The rally drove the Dow industrials to 3½-year highs. Now the question for many on Wall Street now is whether the fourth-quarter rally can continue into 2005.

Major Market Indices

A tough 2005?
Most Wall Street strategists expect 2005 to see moderate gains, but many also agree that a continuation of the U.S. dollar’s decline, the likelihood of a series of interest rate hikes and the potential for higher energy prices could all conspire to rob the market of its gains. And statistics are not on Wall Street’s side: Data from the Stock Trader's Almanac, which tracks market trends, show post-election years are often the weakest of the four-year presidential cycle.

Stock market observers expect Wall Street to rally on into January, if not further, benefiting from the so-called “January Effect,” period, a seasonally strong phase for equities, when money managers reposition their portfolios for the year ahead and move funds back into the market. But the market faces its first test in late January when Iraq holds its elections. A delay in the vote, or an increase in violence, could weigh heavily on the market, analysts say.

Alfred Goldman, chief market strategist at A.G. Edwards, sees a number of headwinds for the market in 2005. Economic growth and corporate earnings growth are not expected to be as strong next year as in 2004, he says, and with the market’s current bull market over two years old, it may be getting tired.

“In 2005 we’ll be in the third year of a rock ‘n’ roll market, but the market can’t rock ‘n’ roll forever and its legs are going to be getting creaky,” Goldman said.

“It all depends on whether people think that slower earnings growth and a slower economy spells bad news, or whether they think it’s a good sign because it’s a continuation of the growth we have seen,” Goldman continued. “For now, the mood on Wall Street is positive and it’s a glass-half-full situation, but no one knows when that will change.”

Rising rates a worry
David Joy, capital markets strategist at American Express Financial Advisors, thinks the biggest problem for the stock market in 2005 will be a steady rise in interest rates.

Joy expects the Federal Reserve to continue raising its benchmark federal funds rate in 2005, perhaps as high as 4.5 percent, which could push the yield on the 10-year Treasury note over 5 percent. In an environment where corporate earnings growth is expected to slow to around 10 percent from about 20 percent in 2004, that could cause stocks to struggle.

“At the very least, if we get positive returns, they will be mild, in the mid-single digits,” he said. “But I wouldn’t be surprised to see the market post mildly negative gains in 2005. I hope I’m wrong about that, but it’s a real possibility. Stocks could deflate a bit in 2005.”

Joy sees better investment opportunities offshore, where there is less interest rate pressure and better earnings growth potential. He expects emerging markets, especially in Latin America, to be driven by commodity exports to countries like China and India. In Japan, he sees signs of consumer demand picking up, and expects European Union countries to see growth, but adds that the current strength of the euro in relation to the U.S. dollar could present a problem for euro-zone exporters.

Given the outlook for higher interest rates, Jim Stack, president of InvesTech Research, a stock market research and money-management firm based in Whitefish, Mont., recommends moving funds out of stock sectors sensitive to a rising interest rate environment — like financials — and into non-cyclical stocks — like consumer durables and healthcare stocks — which are less sensitive to economic cycles.

“We are still bullish on this market, but we are at that point where good economic news, if it’s too good, could be bad news for the stock market and could mean interest rate danger going into 2005,” Stack told CNBC. “We might get more rate hikes at a faster than expected pace.”

The Associated Press contributed to this report.

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