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Merrill Foresees Modest Stock Growth in 05: Lower GDP May Negate Promise of Year Ending in Number Five


NEW YORK - If history is any indication, the U.S. stock market should enjoy a measure of growth in 2005.

That's because, as Merrill Lynch Investment Managers President and Chief Investment Officer Robert Doll pointed out, experts must look back as far as the mid-1800s to find a down year in the Dow Jones Industrial Average when that year ends with the number five. In fact, years ending in the number five have witnessed average S&P 500 growth of 28.5% between 1929 and 2003.

"Let's hope history repeats itself and the string continues," the 50-year-old Doll said during his annual year-ahead outlook at the World Financial Center last week.

Wishful thinking aside, however, Doll is predicting modest growth, or "a muddling-through year," for the U.S. stock market and economy over the next 12 months. Furthermore, as earnings slacken and interest rates rise, low-beta, larger-cap equities should outperform the high-beta, smaller-cap stocks that were red hot in 2004.

Doll also said that prevailing expectations for GDP growth in the 3.5% range may be too optimistic, grounding his skepticism in the flagging spirits of Main Street.

"Our view is that economic growth will be a little less robust than the consensus, mainly because of the slowdown in the U.S. consumer," said Doll, who thinks GDP growth of somewhere between 3% and 3.5% is a more accurate outlook. "Not that the real economy or the consumer is going to be disappointing, just less robust than the great year we saw in '04 and the pretty good year we saw in '03."

Leading consumer confidence indices bear him out. The University of Michigan's closely watched Survey of Consumers reported last week that consumers are expressing caution over the prospect of higher interest rates and sluggish job creation.

"While more families expected good times financially in the economy as a whole, they nonetheless expect the pace of growth to be somewhat slower in 2005 than 2004," said Richard Curtin, the survey's director.

The Conference Board's Consumer Confidence Index, which had been on a three-month slide before rebounding in December, indicates that consumers are upbeat about economic expansion in 2005, but that news was tempered by a slip in chief executive confidence in the national economy for the third consecutive quarter.

"Expectations are that the economy will continue to grow in 2005, just not as fast as it did in the first half of 2004," said Lynn Franco, director of The Conference Board's consumer research center in New York.

Back on Wall Street, Doll anticipates stocks will outperform bonds and cash for the third consecutive year. Bonds could even finish in the red this year, he offered. However, equity returns will be off last year's pace, he said, without predicting any specific target or target range for returns, saying only that a slowdown in performance is historically consistent with bull markets, which tend to post smaller gains as they expand. As the course of the year plays out, the average stock will underperform its benchmark, but large-cap stocks and high-quality will outperform small-cap and low-quality for the first time since 1999.

"Our view is that earnings growth is slowing and interest rates are moving up, but we're nowhere near the point in time where the Fed has to take the punch bowl away [and] create a recession to slow things down to cycle inflation. We're just maturing in the economic cycle and bull markets tend to follow that sort of suit," he explained.

Doll expects corporate earnings growth to hover close to the historical average of 7%, slightly below the consensus average of 10%, while measured interest rate hikes by the Fed will continue until the Fed funds rate rises from its current 2.25% to 3.5% by year-end. Expect that hike to drive 10-year Treasury yields to 5%, he added.

"One of the reasons we think rates will go up [is] advancement in the economic cycle, further evidence of [higher] oil and other commodity prices and the decline in the dollar, which imports some inflation," he said. But most notably, "the Fed has signaled that they're hell-bent on moving rates to normal, whatever normal is."

Still, Doll added, given the fact that the economy will be expanding above its historical trend at all speaks well of where it now stands, given a formidable array of counter-forces, such as the inevitability of higher interest rates, volatility in the energy market and lower productivity levels.

Doll, who manages nearly $500 billion in equity and fixed-income mutual funds at Merrill Lynch, expects the rest of the world to follow suit on higher interest rates. Most of the world's banks, he noted, have started to follow the Fed's lead and raised short-term interest rates. As a result, Doll anticipates that global GDP growth will slow from about 4% in 2004 to around 3.1% in 2005.