Better Days
The economy is healthy, if not booming. Plenty of great stocks are cheap. Add it up, and you get opportunity
By Michael Sivy

(MONEY Magazine) – After the stock market's sluggish performance in 2004, it's fair to ask whether the bull run is over. Is that all there was? Not by my calculations. Better days lie ahead, and there's even a chance of a sharp run-up in the Dow starting in 2005. Large swaths of the market are now undervalued, and many giant growth stocks are out-and-out bargains. Buy the shares of those top-quality companies at today's prices, and at some point during the next 10 years, they'll almost certainly be way ahead of the rest of the market.

You may not even need to wait that long for a big payoff from today's bargains. This bull market has slightly underperformed the average recovery almost since it began in October 2002. Over the past year, share prices have been held down by concerns about terrorism, Iraq and oil. But as the election season drew to a close, investors' dark mood started to lift, and since then the bull market has been closing the gap with historical benchmarks. At this point, in fact, it seems to be changing from a weak recovery to one that has a strong second advance. If the economy performs as expected and the geopolitical environment improves a bit, the market could take off, gaining as much as 60% over the next two years.

There are three reasons for my long- and short-term optimism, which are laid out in the charts accompanying this story. First, after several years of depressed profits, earnings prospects are now much more positive. Second, the outlook for inflation and interest rates is actually quite good. Inflation remains low, and that means interest rates don't have to move much higher. And third, price/earnings ratios for top stocks—and particularly big growth stocks—are at the lowest levels in 10 years. Shares of companies that can increase their earnings at a compound annual rate of 12% or more are investors' favorites when the economy and the stock market are running hard. At such points, the most popular of these stocks trade at P/Es of 30 to 50, and in the case of tech darlings like Cisco, even as much as 100.

Now the situation is the opposite of what it was in 1998 and '99. Then, growth shares were way overpriced, and the smart move would have been to shift slowly to more conservative issues. But that's hard to do when everyone else is whooping it up. Today it's clear that big growth stocks are cheap, and you have a window of opportunity to load up on them before the crowds return.

My case for a possible surprise stock run-up in the next year or two is based on the fact that most recoveries reach a turning point after 30 months. Strong recoveries get a second wind that carries them to further big gains over the following 20 months, while weak ones begin sliding toward the next bear market.

The current bull market will reach the 30-month mark in April. To see how it is shaping up, we compared it with past recoveries, using data compiled by the Leuthold Group in Minneapolis. We divided the 21 bull markets since 1900 into seven strong, seven moderate and seven weak ones. As you can see in the first chart, the current bull market looked slightly subpar until recently. The bear of 2000 squeezed the worst excesses from the market, and it ground down growth stocks in particular. A strong rebound would have been natural once the 2001 recession ended. The market never built up a head of steam.

Instead, the anxiety many investors felt after suffering such big losses was compounded by post-9/11 fears about terrorism, the war in Iraq and the volatile price of oil.

But it's not hard to imagine that today's problems will look less threatening a year from now. Afghanistan and Iraq could achieve some degree of stability, and oil could be a source of good news as well. High prices stimulate exploration; as new supplies come on the market over the next 18 months, the price of crude could drop below $35 a barrel. Add to that continuing economic growth at a rate high enough to create jobs and chip away at unemployment but low enough to limit inflation, and the market's short-term prospects start to sound exciting.

When stock prices are depressed, you don't need fantastically good news to get a rally—just less bad news. In fact, this recovery's anemic start could turn out to be ideal from a long-term investor's point of view. Booms like the late 1990s aren't the best environment for serious investors—you can make a quick buck, but the bust that follows wreaks havoc on long-term wealth building.

Stock prices fare best with a mix of slightly above-average growth and low inflation that encourages higher P/Es. With steady economic expansion and inflation below 3%, it's likely that returns will top historical levels of 11% or so a year, including dividends.

What could go wrong

Bright as the future may look, all forecasts are just educated guesses, and I'm certainly not advocating that you ignore the risks. The worst-case scenario du jour is a collapse in the value of the dollar (see the box on the next page). But there are other possible causes of concern that could stall the market's recovery.

For starters, Federal Reserve chairman Alan Greenspan could raise interest rates too much. He has already hiked short-term rates four times in six months. However, if inflation remains low, a further rise in interest rates could be too much for the economy to absorb. The good news is that Greenspan generally avoids such mistakes.

Another concern is that consumers, who account for two-thirds of the total economy, might put away their wallets. Many Americans are carrying too much credit-card debt, and any upturn in mortgage rates could erode property values and make homeowners feel less affluent. Here again, though, the odds favor a happier outcome, in my opinion. At current interest rates most consumers don't have a problem carrying their debt. And the risk to home prices seems overstated (for more on real estate, see ''Last Hurrah" on page 63).

The final major risk is a big spike in the price of oil. That's conceivable if terrorists start hitting oil production and refining facilities. But as I said earlier, the more likely scenario is that prices fall as supplies increase. There are also smaller possible surprises that might hurt particular market sectors. Here are three examples.

Productivity gains could diminish. No one really understands why increases in productivity have been so strong over the past decade. Some people say the personal computer has transformed the service sector. Other say Americans are simply working harder. Whatever the explanation, high productivity helped maintain growth with low inflation during the 1990s. If that stops, growth may be weaker and inflation may be higher; service companies would suffer most.

The budget deficit could fire up inflation. To date, the deficit hasn't had much of a negative effect on growth or consumer prices. But the 1.7% gain in the producer price index for October is more than double the rate for recent months. That pushes wholesale inflation over 12 months to 4.4%. If that rate continues, companies that can't pass price increases on to customers stand to get hurt.

More industries could be the target of investigations. The drug and insurance industries have been rocked recently by civil lawsuits and possible criminal charges. It may appear that the worst offenders have already been exposed, if not always punished. But other firms could be targeted, and existing disputes may get more serious.

There are dozens more scenarios, but there's no point in trying to sidestep these risks completely. Yes, you could keep your money in totally safe investments, but the returns would be so low that you'd fall short of your long-term goals. The best you can do—in 2005 or any other year—is make prudent choices about the likeliest future outcomes and always hedge against the possibility you could be wrong. That's why proper diversification is so important. Get that right, and you'll be braced for most of the surprises that come your way.

The way to play

So here's what to do: Take advantage of the buying opportunity in top growth stocks. You can start by checking out our "Best Investments of 2005," which begins on page 66. There you'll find opportunities in growth stocks and mutual funds that will work for a variety of investing styles.

If you've got a long time frame and can handle short-term price volatility, increase your weighting in the more aggressive growth areas, including technology. For some people, it's okay to have as much as 60% in such stocks.

If you can't afford to swing for the fences because your time horizon is shorter than 20 years, you should favor more mainstream growth—consumer products and drug companies rather than tech and biotech. Balance those holdings with blue chips that pay decent dividends.

Even if you're basically conservative, you may want to add a little low-P/E growth to spice up your portfolio, such as Citigroup at 10 times estimated 2005 earnings.

Most important, don't feel you need to move all your money into growth at once. The really big play is the long-term gain. It would be nice to get in on the ground floor and then see an immediate market pop. But keep your eyes on the prize. What really matters is that you reach or surpass your financial goals 20 years down the road, when today's troubles will be only a hazy memory.