Authority's thoughts on investing in 2005

Dr. Richard Marston is the James Guy Professor of Finance at the Wharton School of the University of Pennsylvania and a recognized authority on international finance.

Dr. Marston outlined his thoughts in a recent report, "Investing for 2005," on various aspects of the markets and economy for the year. I have provided some of his thoughts:

The start of a new year is always an opportune time for investors to review their portfolios. Let's start by taking a look at the 2005 economic outlook and what it is likely to mean for the U.S. stock market.

We saw a number of positive economic developments over the past year and a half.

Although the economic outlook for 2005 generally seems bright, there are several factors that could prove troublesome. One of the most important is the price of oil.

Since reaching a peak of $55 per barrel in October - a record high in nominal terms, although below the inflation-adjusted peak of the late '70s - prices have retreated significantly. The most likely scenario is that they will remain stable or continue to decline gradually in 2005. If, however, oil prices were to return to their previous peak or move higher, I would worry about the effect on growth.

The rise in equity prices that began in February 2003 has been driven by the powerful surge in profits brought about by the economic expansion. The four quarters beginning in July 2003 saw roughly a 60 percent rise in reported earnings, which was a clear result of accelerating growth.

This is in keeping with the typical cyclical pattern. In all nine economic recoveries since 1950, the return to growth has brought rising earnings and rising equity markets.

Moving forward, the rate of corporate earnings growth almost certainly will slow. This is a natural progression for the middle stages of an economic recovery. However, as long as earnings continue to rise, the outlook for equities should remain positive.

While there are issues to worry about in any economic environment, the best evidence suggests the U.S. expansion remains on track. Although the rate of corporate earnings growth is likely to slow in 2005, it should remain positive. Investors should make sure their portfolios are positioned to reap the benefits of continued growth.

Given the expected trend toward higher interest rates, bonds and other fixed-income assets are likely to post relatively low returns in 2005. At best, investors should expect returns that are roughly in line with yields - a major departure from the past two decades, which saw significant capital gains on many fixed-income assets. Nominal bond yields in the 5 percent range would imply real rates of return of roughly 2.5 percent, consistent with historical norms but less than what many investors have come to expect.

Having lagged the United States so far in the global recovery, Europe and possibly Japan should be poised for faster growth in 2005. As in the United States, economic acceleration should have a proportionate effect on corporate earnings. A weaker dollar also is likely to bolster foreign equity returns, particularly in Asian markets.

For most investors, the best way to meet the challenges of the coming year is not to make sudden or extreme shifts in their portfolios. Rather, they should review their strategic allocations then carefully consider the potential risks and benefits of any tactical adjustments designed to take advantage of shorter-term market trends.

Of course, these decisions will depend heavily on each investor's specific goals and tolerance for risk. In general, however, Marston recommends investors make sure their long-term and short-term allocations are consistent with the following key points:

n A long-run commitment to equities

n Recognition that the main role of bonds is to reduce portfolio risk

n The importance of diversification across different equity categories, including large-cap and small-cap, value and growth, domestic and international.

By keeping these basic principles in mind, investors can best ensure their portfolios are positioned to grow long-run wealth - not just for 2005, but for the long run as well. Obviously, past performance is no guarantee of future results. For a full copy of Marston's report, e-mail me at William.a.Creekbaum@smithbarney.com or call 689-8704.

Smith Barney does not provide tax and or legal advice. Please consult your tax and or legal advisers for such advice.

n William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.