The Economic Outlook for 2003: A Promising Start (page 1 of 2)

So far, the signs are encouraging. The Standard & Poor's 500 rose nearly 6% in the first nine trading days. Historically, the start of January has been a good indicator of full-year performance, though there have been plenty of exceptions.

The possibility of war, the continuing sluggishness of the economy, excess production capacity and debate over President Bush's $674 billion tax-cut package hang over the market. "The economy looks like it's going to move along," says Wharton finance professor Marshall Blume, echoing a widely held view that recovery is taking hold. "Stock prices will move along, too. We'll probably have some inflationary pressure, but not much."

After three years of falling prices, stocks are no longer overpriced, he says. The price-to-earnings ratio for the S&P 500 has fallen to below 20, based on earnings estimates for the next 12 months, compared to more than 30 when stocks peaked in March 2000. The historical average is around 15, but many experts think that low interest rates, low dividend yields and other factors make a level of around 20 the norm today.

"It's always hard to predict where the stock market is going to go," Blume notes. "But the stock market, assuming you buy it at a reasonable price, tracks earnings. And if earnings go up, stocks will go up ... All the forecasts say earnings per share are going to go up. They're not going to go up [very fast], but they are going to go up."

A survey of 54 economists by the newsletter Blue Chip Economic Indicators found most expect corporate profits to rise 8% during the year. That would be the biggest increase in five years. The economists said economic activity will pick up as the year progresses, due to stimulation from government military spending and a decrease in the "risk aversion" that has held back spending by businesses. The economy should expand at a 2.7% annual rate in the first quarter, compared to a 2.4% rate in 2002, with the rate rising to 3.8% in the fourth quarter, those surveyed said.

Stronger economic growth will push interest rates up, and the economists predicted the Fed Funds rate will rise from today's 1.25% to 2.13% by the end of the year. They project unemployment to fall from the current 6% level to about 5.7% in the fourth quarter.

Richard Marston, professor of finance and economics at Wharton, cautions that forecasts often prove wrong, noting that a December survey by Barron's found six of seven forecasters at top securities firms had predicted at the start of 2002 that the S&P 500 would rise by year end. The positive predictions ranged from a small 4.5% gain to a stunning 36.8%. In fact, the index fell 23.4%. Only the Bank of America analyst was anywhere close, having predicted a drop of 17.3%.

"It was a complete surprise - what happened in 2002," Marston says. Most experts had thought the market declines of 2000 and 2001 had wrung out with the excesses from the tech bubble of the late 1990s. But forecasters could not predict the series of corporate scandals that rocked the market in 2002.

"Through the spring it was just one company after another, and it got uglier and uglier," he notes. "The accumulation just overwhelmed investors. I think WorldCom was the straw that broke investors' backs." Nonetheless, Marston adds, the stock market does tend to rise when investors anticipate a recovery that has not yet arrived.

During the last four recessions, the S&P 500 hit bottom several months before the recession ended, then followed with big gains.