Many cheery returns

The fourth quarter gave investors something to celebrate. But 2005 may be more subdued.

Mutual fund investors can celebrate the success of 2004: The fourth quarter saw the strongest rally of the year, stock indexes hit highs not seen since before the Sept. 11 attacks in 2001, and the market experienced its first two-year rally since 1999.

That's something worth tooting your horn about - unless, of course, you plan on extending the celebration into this year.

A piece of advice for 2005: Stow that party hat. Although the consensus outlook remains positive, you may have to unlearn the lessons of 2004.

For example: Is the hot money in Latin America? It sure was last year. Latin American funds gained more than 21 percent in the fourth quarter and were up more than 38 percent for the year, according to Lipper Inc. But analysts expect these funds to cool off somewhat in 2005, particularly if commodity prices fall.

Small-cap and mid-cap funds also performed quite well last year, but they could be overtaken this year by large-company funds, especially funds that invest in big industrial companies, analysts say.

And what about those high-yield, or "junk," bond funds? They provided some of the best returns among bond funds last year. But if interest rates continue to rise, they could be among the hardest hit as higher rates drive bond prices down.

There's one lesson from 2004 that's probably worth memorizing for 2005: Don't listen too closely to projections for the new year.

At the beginning of 2004, many market analysts said stocks would have a good first half of the year and a not-so-good second half. The reality was just the opposite. Although broad stock market indices such as the Standard & Poor's 500 index finished the year gaining 9 percent, most of those gains came in the second half.

Election-year dynamic

"A lot of people expected a big run early in the year and a downturn later in the year," says Harry Clark, president of Clark Capital Management Group in Philadelphia. "They didn't get it. It was a typical election year. Usually the first seven or eight months are down in an election year and that's what happened."

"It's been a strange year," agrees Martin Vostry, a research analyst at Lipper. For example, "we expected that at some point in 2004 large-cap funds would start outperforming small caps. Small caps have outperformed over the previous five years. We and a lot of other analysts expected that to reverse itself in 2004 and that definitely didn't happen."

In addition, value funds, which usually don't do as well as growth funds in a rising market, outperformed growth funds. The average large-cap value fund returned nearly 12 percent for the year, according to Lipper, compared with 7 percent for large-cap growth funds. In the last three months of the year, large-cap growth funds made up ground, as they advanced 9.7 percent, while large-cap value funds gained just below 9 percent.

As confusing as the past year seemed to be, there was some logic behind the results, analysts say. Growth funds lagged, for example, because many of their portfolios were concentrated in both electronic and healthcare technology, Mr. Vostry says. "Those sectors tended to under- perform in 2004."

Value funds, meanwhile, tended to be more heavily invested in natural resources, utilities, and financial services, all of which turned in good to excellent performances. Natural resources - led by oil-company stocks - performed especially well as oil prices topped $50 a barrel in the summer before settling in at a still-profitable $43 a barrel, a $10 increase for the year.

As for 2005, depending on who's talking, the S&P 500 will gain 10 to 15 percent - or it will end up about where it started.

Mr. Clark, for one, thinks the stock market could fall 10 to 15 percent in the middle of the year, before finishing slightly positive. "I see a decent but volatile year," he says. "It will scare the little guy from putting money in or scare him into taking money out. One or the other."

Restrained business spending

The market will make modest progress, agrees Brian Rogers, chief investment officer at T. Rowe Price in Baltimore. Corporate earnings have been reasonably strong in the past few months, Mr. Rogers notes, and he expects that pattern to continue this year. He also points out that companies are still reluctant to increase capital spending, which has resulted in improved balance sheets, and that dividend activity has been positive, with more than 200 companies raising dividends in 2003. He estimates the S&P 500 will return from 5 to 9 percent.

This may also be the year that large-cap stocks finally begin to outperform their small-cap counterparts after several years of lagging them, Rogers says. For one thing, smaller and mid-size companies will find it harder to squeeze more profits out of their operations, a situation that will make high-quality companies with long histories of steadily increasing profits more attractive.

While analysts are somewhat optimistic about this year, they also see reasons for caution.

"I tend to look at the deficit within the US," Vostry says. "I see that as potentially problematic. The hope is that interest rates won't have to rise substantially as a result." Even though the Federal Reserve Board has raised short-term interest rates five times in the past seven months, intermediate- and longer-term rates have stayed relatively low. That's because investors felt the Fed was controlling inflation.

But heavy borrowing by the Treasury Department to finance the deficit could push up longer-term rates, creating a difficult climate for both stocks and bonds, Vostry explains.

Given this outlook, the advice may seem trite, but it also could be particularly useful in 2005: Stay diversified and don't look for a repeat of short-term trends.

"I think bonds have as much risk as stocks right now, with interest rates going up," Clark warns. For his clients' portfolios, he is emphasizing funds whose holdings are somewhat more defensive, with an emphasis on consumer goods and energy.

"People are going to keep spending," he says. And "energy is going to stay strong, I believe. I don't think oil prices will go down nearly enough to cause energy companies problems with their earnings."

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