NEW YORK (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 percent over the next two years.
There are three reasons for my long- and short-term optimism.
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 percent 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 (Research), even as much as 100.
Now the situation is the opposite of what it was in 1998 and 1999. 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. 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 percent, it's likely that returns will top historical levels of 11 percent or so a year, including dividends.
Bright as the future may look, all forecasts are just educated guesses, and I'm certainly not advocating that you ignore the risks. Click here for "What could go wrong."
The way to play
So here's what to do: Take advantage of the buying opportunity in top growth stocks. Subscribers can start by checking out our "Best Investments of 2005.". 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 percent 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 (Research) 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.
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