Financial markets returned to normalcy in 2004 after the irrational exuberance of the late 1990s, the collapse in 2000, the three-year economic downturn that followed, the recovery in 2003 and the war in Iraq. In the United States, the indexes rose by about 9%. In Europe and Japan, they rose by 8.5% — practically in line with historic returns of stock markets over the last century. In 2005, the great challenge will be to maintain this relative, positive sense of calm. Experts consider that to be a feasible goal, although the weak growth of the European economy will be a significant obstacle.


An election year, 2004 was true to historical tradition, winding up in positive territory despite lateral movement throughout the year. Ultimately, the S&P 500 finished up 9.3% for the year, while the technology-rich Nasdaq Composite rose by almost 9%. In Europe, the indexes closed up by nearly 7.5%, with the exception of Spain where the market gained more than 17%. Many emerging nations wound up at their historic highs, including the markets in Eastern Europe and Latin America.


According to consultant Sergio Torassa, former professor of finance at the Pompeu Fabra University, “This has been a very good year, and it is hard to think of investors who invested in the market and lost money. A year ago, in 2003, almost everyone was caught by surprise, but this year was different. However, there are still many investors who are reluctant to return to the market and run the risk that it won’t go up any further.”


The past year was practically the only one in which share prices rose in line with the historic average for markets in the twentieth century, about 8%. It followed several years of sudden shocks, unrestrained optimism and awful pessimism. First, there was the “irrational exuberance,” as Alan Greenspan, head of the U.S. Federal Reserve, described the stratospheric levels of stock prices, especially in the technology sector, during the late ‘90s and early 2000. Those excesses were wiped out by the dramatic falls that brought indexes to their multi-year lows after the brutal attacks of September 11, 2001, which led to the wars in Afghanistan and Iraq.


For 2005, experts foresee the same trend of modest positive returns on investment. According to Salvador Rojí, professor of financial economics and accounting at the Complutense University of Madrid, “It looks like corporate share prices will continue to move up. However, there is a strong consensus that the upside potential now is much lower than, say, during the hysteria of 2000.”


Torassa is also expecting the markets to have positive results. “These days, a lot of money in the real estate market is about to enter the stock market. Share prices could offer a return of between 8% and 10% over the next year, although that number could vary quite a bit.” In his view, “If you add dividends of about 3% to those figures, as in the case of Spain and Europe, you have a good story.”


Where to Invest

Nevertheless, there will be no easy pickings. Investors will have to search for stocks that turn a profit. Manuel Romera, technical director in the financial sector of the Instituto de Empresa, says, “It is going to be very important to make the right choices when choosing markets and stocks. We are seeing more and more differences between those assets that are doing better and those that are doing worse.”


Financial analysts agree that the upside for markets is more limited after the positive performance of the past two years. Economists also expect economic growth to slow down. According to the International Monetary Fund, global GDP growth will amount to 4.3% in 2005, down from the anticipated growth rate of 5% for 2004. Given these circumstances, why invest in stocks?


Torassa argues that “variable income investments are the best choice by a process of elimination. It makes no sense to invest in money markets because current interest rates – 2% in Europe and 2.25% in the United States – mean a loss of buying power if inflation gets any higher. Something similar is involved with fixed-rate investments, while price rises in the real estate market now tend to be more moderate.”


“There are few investment alternatives,” agrees Romera. “Generally speaking, the prospects are for a slowdown in global growth, so the most important thing will be to choose wisely. We are seeing more and more differences between good performers and poor ones,” he adds.


Where should investors look? According to Romera, “The key markets will be the United States and China — the U.S. because of its productivity and efficiency, and China because of its productivity and low costs. These are the countries that are growing the most. They are pulling along the other global economies. Markets where investors can take advantage of rising raw material prices are Australia and South Africa. In other regions, such as Latin America, investors will have to fine-tune their selections. There are some attractive countries, such as Chile which is benefiting from the rising price of copper.”


Torassa suggests that “one very profitable choice could be Latibex,” Latin America’s euro-denominated stock market, which has risen more than 100% from its level of 20 months ago, before the Iraq war began. “There are many Latin American companies managed by Spaniards that have a very attractive risk-reward ratio. And there are also many mining companies that can profit from rising prices of primary products.”


Stagnation in Europe

When it comes to European markets, experts agree that, in terms of valuation, “they are the cheapest,” as Torassa puts it. However, European markets also present some of the largest risks because of the weakness of Europe’s economy. “Europe will be one of the largest problems for 2005, with the euro where it is – it closed 2004 at above $1.36, its historic high relative to the dollar – and the economies so weak,” says Romero. “There is the crisis of structural unemployment, and the impossibility of lowering interest rates. It’s a very complicated landscape. Structurally speaking, Europe has not been active enough.”


The consequences are serious. In France and Germany, the two countries damaged the most by the euro’s strength, unemployment rates are 9.9% and 10.8%, respectively. For France, that is the highest level in five years; for Germany, it is the highest in eight years, according to data published recently. Moreover, the French economy stagnated during the third quarter, which could leave its annual GDP growth rate close to 2%, well below earlier forecasts.


“Here’s the problem,” adds Torassa. “Europe gets even weaker if interest rates wind up having a very damaging impact on its economy. If the euro were to rise even further, Europe would need to make adjustments to compensate for the impact, in order to improve its competitiveness. Structural reforms are essential. Either we get started working on that now, or we will have problems. Germany is taking steps, but very slowly.” Nevertheless, Torassa remains hopeful. “If there is a positive surprise in Europe, and competitiveness improves, stock markets in the region could enjoy positive returns for a longer period.”


The Foreign-Exchange Market

The danger of stagnating European markets is closely tied with anticipated changes in exchange markets. However, Torassa and Rojí expect that the depreciation of the dollar will start to slow down, or that the euro’s rise will even be reversed. According to Rojí, “The dollar is going to keep dropping, but everything is going to depend on whether Asian central banks will want to maintain the current situation. If they no longer trust the U.S. currency, there could be a significant sell-off in the dollar; it could lead to a rapid and damaging depreciation in the U.S. currency. In my opinion, the dollar has already fallen too much, and should rise.”


Torassa does not believe that Asian central banks will lose confidence in the dollar. “This risk is very much under control. There have been rumors about this possibility ever since the euro was at $1.20, yet nothing has ever happened.”


Torassa even sees current exchange-market conditions as an investment opportunity. “If the euro rises to $1.40, as the current trend now appears to be moving, it could be a good time for investing in American stocks. Although U.S. shares provide only modest returns, European investors could play a game of dollar appreciation.” However, he warns that “it is very risky to make predictions about foreign exchange markets.”


Other Dangers Ahead

Another danger in 2005 is the possibility that inflation will get out of control because of rising energy prices. Although the Federal Reserve is cautiously studying that possibility, Torassa and Rojí think it is unlikely. They argue that the price of oil has gone up not simply because of structural reasons, but also because of speculation. They expect energy prices to remain around their current levels or even drop slightly.


Other factors could also act as a counter-weight to inflation, keeping it at a moderate level. One key factor is China, which also plays a causal role in the run-up in crude oil prices because of its growing demand [for imported oil]. According to Rojí, “Clearly, on the one hand, China is imposing upward pressure on raw materials prices, but on the other hand China is keeping prices low for manufactured products. Go shopping and you’ll see that products made in China are getting cheaper. This has a positive impact worldwide because it contains inflation. If prices in Western countries go up, China will have to adjust its costs and improve its productivity. China is becoming an engine of economic growth.”


If there are no negative surprises, the New Year could provide moderate gains, reconfirming that stock markets have gone back to their historic average rates of return. One odd statistic favors the markets: During the last century, stock markets always wound up positive in those years that ended in ‘five’ [as in 1985, 1995]. Although this statistic has no theoretical foundation, it could be an encouraging omen for 2005.