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Merrill Lynch Banks on Second Half Rally: Equity Markets to Rise Against Economic Slowdown

Muddle through.

That's the sort of euphemism that might send money managers scrambling for meaning, much as they do whenever Fed Chairman Alan Greenspan speaks, but it's exactly how Merrill Lynch Investment Managers President and CIO Bob Doll characterizes the capital markets in 2005.

"Some pluses, some minuses, no big numbers," Doll said of market returns for the first six months of 2005, during a recent mid-year investment update.

"A muddle-through environment [is] a lot of rallies, only to be followed by declines, and vice versa, and we think we'll get more of that as the year unfolds."

For example, cash gained 1.3% over the first six months of 2005, while 10-year U.S. Treasury bonds added 4.1% and U.S. high-yield bonds rallied by 1.1%. But 0.8% loss in the S&P 500, a 5.1% deficit in Nasdaq and a 3.7% drop in the Dow Jones Industrial Average tempered those pluses.

Such unevenness can also be discerned in the behavior of mutual fund investors thus far in 2005. While mutual fund stock investors added nearly $150 billion to their holdings during the first half, according to New York research firm Strategic Insight, that money is broadly diversified between international and U.S. equities and fund-of-funds. Furthermore, value continued to dominate growth.

Value Rules

"With investors' tendency to react to, not anticipate, the cyclicality of style trends, value funds may continue to lead investors' demand during the coming months," said Avi Nachmany, director of research, Strategic Insight.

According to Financial Research of Boston, international fund flows netted roughly $76 billion over the first six months of 2005, versus $50.8 billion in the first six months of 2004. Domestic equities, however, have netted just $36.2 billion so far this year, down a whopping 72% from $108.27 billion over the same period in 2004.

Perhaps more dramatically, data from New York-based Lipper indicates that through the first five months of 2005, U.S. domestic equities have eked out just $2.94 billion, as opposed to $75.73 billion through he first six months of 2004.

The broader markets, however, are gathering a bit of momentum, Doll said.

"Over the last quarter and year-to-date, there has been some recovery in the equity markets after a disappointing first quarter," he said.

Doll expects the two-steps-forward, one-step-back environment to persist throughout the year, although he does anticipate that equities will enjoy a modestly better second half.

"When all is said and done," Doll said, "equities will have been, as was the case in 2004, the financial asset of choice."

Lack of Clarity

So what's been holding investors up?

First and foremost, Doll said, is a lack of clarity surrounding short-term interest rates. On June 30, the Federal Reserve completed its ninth consecutive interest rate hike, moving rates to their current 3.25%. Another hike is expected when it is scheduled to meet this Tuesday, although Doll and many of his colleagues feel that might represent the end of the tightening cycle.

"The consensus says at least one more increase, and then they'll stop," he said. "The struggle the equity market has had is the uncertainty of how far the Fed will go and what will the economy and the earnings environment look like when the Fed is finished. Once the equity market gets some more visibility and confidence around that, we can have some further rallying.

"In fact that's the main reason we think we've had the rally in the last month or two," Doll reasoned.

Stock Rally

Although it will take a stronger second half, Doll fully expects the stock market to outperform cash and bonds for the third consecutive year.

History, he said, is on his side. For instance, the average gain in the third year of the eight bull markets since World War II is 2.9%, which isn't a far cry from the 3.1% gain Doll predicted at the outset of 2005.

In addition, growth in the first years of the 14 presidential election cycles since World War II has been somewhat slower than the second half. Finally, since 1929, all years ending in five have witnessed positive gains in the S&P 500.

Despite his optimism for the equity markets, Doll does foresee a slowdown in U.S. GDP growth, from 4.4% in 2004 to a high of 3.5% in 2005, and consumer spending from 3.7% in 2004 to less than 3.5% in 2005. Again, he cites short-term interest rates, as well as rising energy prices and an uptick in the U.S. dollar as laggards on growth.

"It is not a disappointment for growth to slow in 2005, it's just that 2004 was so strong and, frankly, for an economy as big and mature as the U.S., unsustainably strong," Doll said.