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The IBR is a publication of the Indiana Business Research Center at IU's Kelley School of Business

Financial Forecast

Edward E. Edwards Professor of Finance, Kelley School of Business, Indiana University, Bloomington

Professor of Finance, Kelley School of Business, Indiana University, Bloomington

The past three years have been tough on investors with declining stock market returns and low interest rates. Furthermore, notable companies such as Enron, Worldcom, and United Airlines have gone bankrupt, wiping out the entire stock valuations of these companies. Add to this mix the ethical lapses of some managers and investment advisors, as well as the lack of responsible corporate governance at many companies, and it is easy to see why financial markets are now on edge with investors wondering whom they can trust.

Not all the news is bad: housing demand remains strong and families who own their own homes have seen rapid increases in value in many markets. Low interest rates have helped stimulate the real estate market, allowing homeowners to refinance at low rates and fuel their urges to consume. Since we forecast many of these trends will continue next year, financial markets are exhibiting a new reality.

Interest rates

Interest rates have generally fallen during the past twenty years, due in large part to wringing inflation out of the economy. Since short-term rates have fallen much more than the long-term rates, the yield curve is the steepest that we have seen since the early 1990s. Historically, the spread between short- and long-term rates is a precursor to economic activity­—the currently observed high spread is generally followed by an expansion and rising interest rates. Thus, we expect to see a slight rise in interest rates over the next year, with the short-term Fed Funds rate in the 1.75 percent to 2.00 percent range and long-term treasury bond yields in the 5 percent to 6 percent range by the end of 2004. Corporate interest rates will also exhibit small increases next year. Mortgage interest rates bottomed out at about 5.25 percent in early summer and have since increased to approximately 6 percent. We expect mortgage rates to also rise over the next year to a level of 6.5 percent. The prime rate will be near 5 percent by the end of the year.

Corporate Profits

Corporate profits are expected to rise about 9 percent next year as the economy continues to grow and recover from the recession. In fact, third quarter earnings this year are expected to be 20 percent above the level of last year. Corporate profits and cash flows continue to be adversely affected by employee health insurance premiums, which rose 14.8 percent last year, and underfunded pension plans, which stand at a $216 billion deficit for the S&P 500 companies. Since stock market value affects the value of many pension funds, an increasing stock market may mitigate this problem slightly. Global competition remains fierce in many markets­—particularly autos, light trucks, and sport utility vehicles—but the continued weakness in the dollar will help exporters remain competitive. In addition, productivity increases will offset gains in labor compensation. Fortunately, the continuing low interest rate environment has enabled many companies to refinance their debt at lower rates and rebuild their balance sheets. Overall, there has been a deleveraging of corporate balance sheets. The generally positive outlook for 2004 will encourage firms to expand capital investment and employment to meet the expected increase in demand for goods and services, as well as replenish reduced inventory levels. We see very few reasons to expect a business slowdown or the cataclysmic deflationary scenario some pundits are forecasting for the U.S. economy.

Stock Market

From the early 1990s to 2000, the stock market experienced an incredible and unprecedented bull run—fueled by increased productivity and declining interest rates due to the drop in inflation. That encouraged many investors to fully commit to stocks as their primary investment asset. Unfortunately, from March 2000 through March 2003, the market (as measured by the S&P 500) lost about 49 percent of its value. Even though the S&P 500 is up more than 30 percent since March 2003, it is still 30 percent below the peak in 2000 and many investors are reluctant to dive back into the market. As the economy continues to improve, we expect to see the stock market also continue to make gains, although at a less spectacular rate than the experience this year. In the long run, we expect the stock market will offer returns 6 percent to 8 percent above treasury bonds, which is in line with the market’s historical average performance since 1926, but well below the returns investors were experiencing in the 1990s. As always, prudent investors should continue to diversify their portfolios, guarding against too much exposure to any individual stock, market, or asset category.

Summary

The financial markets have clearly changed in the past decade and a new reality must be accepted. We cannot remain passive—action must be taken to align our business and investment strategies with this new reality. As that great philosopher Yogi Berra once said, “When you come to a fork in the road, take it.”