By Michael Sivy Additional Reporting by Erica Garcia

(MONEY Magazine) – Are we there yet?" For most of 2003, that was the big question. All the signs said a recovery was coming up soon--but it never seemed to arrive. Now that we've clearly reached our destination--the economy grew at an 8.2% rate in the third quarter--we have a new question: How long will it last? In fact, the outlook for equities over the next five years is brighter than many people seem to think. There are all the usual caveats, of course. Future growth in gross domestic product may not match the third quarter's sizzling pace. Terrorism could always disrupt the economic upturn. Stocks that have run up exceptionally quickly may temporarily give back some of their gains. But overall, the fundamentals indicate that stock market profits over the next five years should be at least a little bit better than the historical average. The market may not soon match its record performance of the late 1990s, but compound annual returns in excess of 12% still seem well within reach. Nonetheless, many investors have lower expectations, in large part because they are still shell-shocked from the extraordinary bear market that only recently ended. That response is understandable--but it's wrong.

Strange as it may seem, many of the factors that made the recent bear market so crushing will now start working in favor of the economy, prolonging the recovery. To understand how that's possible, you have to consider why the bear market was so much worse than the recession that caused it. In this story, I'll examine that question and assess the current upturn. I'll also profile five stocks that have led the recent market run-up but still appear attractively priced. In addition, "Best Investments" on page 64 will look at six stocks that could outpace the major indexes in 2004.

The short explanation for the length of the bear market is that the excesses created by the 1990s boom needed to be deflated--and that took time. As a result, even though the recession lasted only nine months, the decline in share prices--particularly for growth stocks--dragged on and on for almost three years. Now that the bear market is over, the path has been left clear for a long-lived recovery.

Strong productivity gains were one of the key reasons for the '90s boom. And those increases have continued at an unusually high rate. In each of the past two quarters, productivity rose at an annual rate of more than 5%. Those increases will probably diminish as the recovery matures. But for a while, companies will be able to increase their output without hiring new workers and raising their labor costs. As a result, unemployment may remain high during 2004. But it's always a lagging indicator and will eventually come down. Moreover, a brief lag in job creation at the start of the upturn could actually allow the recovery to continue longer than usual.

In the atypical cases where a recovery fails to last at least five years, it's almost always an upsurge in inflation that cuts short the expansion by forcing up interest rates. But the boom and bust of the past nine years have swept away most of the factors that could encourage a resurgence of inflation. Slackness in the labor market will allow companies to boost profits without raising prices. And all the capital spending that occurred in the late '90s has left many companies with considerable excess capacity. Again, the likely result is a recovery that lasts longer than usual.


Inflation is the single most important determinant of stock returns. And nothing could be more positive for share prices than today's exceptionally low inflation rate (see the chart at left). Annual increases in consumer prices have run under 3% since the recession and are expected to remain below that mark for the next five years.

Interest rates are nearly as important. As the charts above show, short- and long-term rates have not only declined considerably over the past 13 years, they are even lower than prevailing inflation rates would predict. At some point, accelerating economic growth will probably push these rates up by at least a percentage point. That probably wouldn't have too much impact on stocks, but it would hurt the prices of long-term bonds. Investors who need income investments should consider high-yield equities rather than long-term bonds such as Treasury issues.


Ultimately, though, it's growth that will propel share prices higher. The Bush administration's tax cuts and open-handed spending are revving the economy. And as the chart on the bottom of page 62 shows, earnings for the S&P 500 are already bouncing back strongly from their recession lows and could continue to grow at a double-digit rate over the next three years.

Even a robust economy would not produce above-average gains for equities if stocks were starting off at unreasonably high prices. But in the wake of the bear market, valuations look quite reasonable today. Conservative stocks are slightly below their historic averages. Growth stocks are at a slight premium--anywhere from 5% to 20%, depending on how you calculate it (see the chart on page 62, top). That premium, however, is more than justified by low inflation and prospects for a rebound in corporate profits.

Stocks are still in the first stages of a recovery. The broad market bottomed in October 2002. Growth stocks began to recover steadily from those lows, but the Dow fell back again in March 2003. Since March, the Dow is up more than 30%. That's still only about one-third of an average recovery, so there's plenty of room for further growth. The potential for growth stocks is even greater, although those are also the shares that have had the biggest short-term gains and would be most vulnerable to any temporary pullback.


I regularly follow 70 large, seasoned companies in my monthly newsletter (800-211-8559; /join). Right now, I'd focus on the industry leaders I mentioned in MONEY's December issue: Applied Materials, Intel and Microsoft in technology; Abbott Laboratories and Pfizer in pharmaceuticals; Citigroup and Washington Mutual among financials; Tribune and Viacom in media; and Home Depot and Procter & Gamble in the consumer sector. Those stocks all look attractive for the long pull. I find three--Citigroup, Home Depot and Washington Mutual--to be especially compelling choices for the next 12 months (we also make the case for Viacom in "Best Investments" on page 64).

Stocks that lead the market coming off the bottom often go on to be top long-term performers. I winnowed the list of 70 blue chips down to eight that have gained more than 35% since October 2002 and still look attractively valued relative to their growth prospects. To recap the three I wrote about last month: Citigroup is the largest and best-diversified financial services stock. Home Depot is cashing in as do-it-yourselfers take advantage of low mortgage rates and a booming housing market. And Washington Mutual is an irresistible value choice with a 12% projected earnings growth rate, a 3.7% yield and a price/earnings ratio below 10. Now here's a look at the five other picks.

--BOSTON SCIENTIFIC (Ticker: BSX; recent price: $36; P/E on 2004 earnings: 22; no yield) produces a variety of medical devices that are less invasive than alternative treatments. The company's two chief markets: cardiovascular, including balloon catheters and stents used to hold open damaged arteries, and gastrointestinal, including devices used to remove colon polyps and treat gastroesophageal reflux disease. In November one of Boston Scientific's drug-coated stents received preliminary approval for domestic use. The product is the subject of patent litigation with Johnson & Johnson, but recent court decisions have been quite favorable to Boston Scientific. Earnings are projected to more than double in 2004.

--FIRST DATA (FDC; $38; 18 P/E; 0.2%) provides a variety of financial information services, including money transfer through Western Union and credit- and debit-card-transaction processing. The company also owns 64% of the NYCE ATM system. First Data is a fairly direct play on consumer spending and has opportunities to expand overseas, particularly in developing economies. The company's money-transfer businesses, already strong in Latin America, could grow rapidly in China, India and Eastern Europe. Earnings are projected to grow 15% in 2004.

--FORTUNE BRANDS (FO; $71; 17 P/E; 1.7%) is a holding company with a mix of top consumer brands. Among them: Moen faucets, Master Lock padlocks, Titleist golf balls, Swingline office products and Jim Beam bourbon. Fortune's brands have been responding well to improvement in the economy. For the third quarter, earnings were up 34% on an 8% sales gain. Results have also been helped by a pickup in liquor sales after years of stagnation. Earnings are projected to grow 14% in 2004 and average 12% a year thereafter. The shares have gained 36% since I recommended them in August but still look attractive.

--MBNA (KRB; $25; 13 P/E; 1.6%) is a leading issuer of credit cards, especially those linked with various kinds of organizations--from alumni societies to animal-welfare groups. This extremely lucrative business has propelled MBNA's earnings growth at a 20% compound annual rate over the past five years. The company's success has been a bit overshadowed by investor fears that consumer spending might falter. But now that an economic recovery has taken hold and job creation is improving, the credit-card business is ready to charge ahead again.

--STAPLES (SPLS; $27; 21 P/E; no yield) saw its earnings grow at a compound rate of less than 10% annually over the past five years, but the recent economic upturn has produced a big improvement on the bottom line. For the third quarter, earnings climbed 22% on a 13% revenue gain. Staples is refurbishing select stores to improve turnover, adding more profitable house brands, emphasizing higher-margin products and increasing marketing to small business customers. Assuming a reasonably strong economy, Staples could achieve 20% earnings growth in 2004.