Stock market back in the game, modestly

Don't spill the eggnog, but the returns on the stock market are finally starting to rival real estate.

After collapsing and floundering for about three years, the stock market is finishing 2004 with a solid 8 or 9 percent gain, following a gain of more than 25 percent last year. Some commentators are also optimistic that the elements are falling into place to make 2005 a positive year as well.

The improving health of financial assets has important implications for the economy. It makes it easier for big companies to raise capital to build new factories, which creates new jobs. Entrepreneurs find it easier to raise money to start new businesses. And companies are back to buying other companies, a form of financial Darwinism, which might strengthen the economy.

Moreover, consumers hear the nightly newscasters talk about stock prices on the rise instead of falling every day. "It's making a big impact on people's sense of wealth, an impact on their spending," says Rod Smyth, chief investment strategist for Wachovia Securities in Richmond, Va.

Since the market hit bottom on Oct. 9, 2002, it's added by some estimates about $3 trillion in value to investors' net worth. For example, an investment of $10,000 in the Standard & Poor's 500 Index on Oct. 10, 2002, would be worth $15,406 today.

But despite this gain, the market so far has "underperformed" other bull markets in their first two years, says Sam Stovall, chief investment strategist at Standard & Poor's. "It could be a late bloomer," he says.

Investors have reasons to be skeptical. The S&P is still 21 percent below its high of about five years ago, and many individuals have long since bailed out. Some are investing in the housing market, which over the past five years has seen the median house price appreciate by 41 percent - compared with a 12 percent net decline in the stock market.

This shift seems to be having an impact on investors' behavior. "I was recently at a meeting with some of our investment advisers, and I asked them how many had clients who had taken money out of the market. About 75 percent raised their hands," says Mr. Smyth. Much of that money is still flowing into real estate, he says, "since everyone wants a piece of a good thing."

However, some new dynamics are in play in the stock market:

• There has been a new spurt of mergers and acquisitions, including a takeover battle for the wireless company Sprint. And software giant Oracle has swallowed People Soft for $10.3 billion. "The mergers are a favorable sign for stocks," says David Kotok, chief investment officer for Cumberland Advisors Inc. in Vineland, N.J. "It's also a sign that very low interest rates create terrific deals, and financing costs are low."

• Investors seemed to be enthusiastic about President Bush's reelection. Since the end of October, when it became clearer Mr. Bush would win, the market has perked up. "I think it's because they view him as relatively light-handed as far as regulatory matters are concerned. He'll be retaining the tax cuts and pressing for tort reform and trying to privatize part of Social Security," says Robert Hormats, vice chairman of Goldman Sachs International. "All of that is considered pro-market."

• There may be some changes in the economy that will benefit the market, including lower oil prices and a weaker US dollar, which permits US companies to compete better with foreign companies. However, these changes may not be powerful enough to change another important trend: The rate of earnings growth is slowing. "We've already seen the peak in profits," says Mr. Kotok.

Whether these dynamics will be enough to move investors from real estate remains to be seen. The Federal Reserve is raising short-term interest rates, including last Tuesday when it hiked them another quarter of a percentage point. "We think they will rise again next year - maybe not every month - and that rise will give the market some headwinds," says Kotok.

So far, however, the rising rates have not affected the long-term bond market, which is governed more by inflation expectations. Mortgage rates, which are linked to the long-term rates, remain reasonable. For that reason, some analysts believe consumers are not overly stretched in their home-buying.

For example, the National Association of Realtors estimates that in the early 1980s, mortgage payments exceeded 30 percent of family income. Now, it's about 18 percent. "The fundamentals of a growing population, tight supply of homes available for sale, and rising construction costs will support home prices moving forward," said David Lereah, chief economist for the National Association of Realtors, in a recent analysis.

But historically, the stock market has outperformed real estate as an investment, says Smyth. Since the 1960s, real estate has risen about 1 percent a year over the rate of inflation. Over the past 200 years, he says, the stock market has risen 6.5 percent over the rate of inflation.

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