Financial forecast.

As usual, the condition of U.S. financial markets is bipolar. The optimistic side is that the financial markets have been able to absorb tremendous shocks during the past three years: the trauma of 9/11; declining stock market returns from the incredible highs of 2000; the bankruptcies of Enron, Worldcom, United Airlines, and others; sweeping legislation to reform corporate governance practices at companies; and unrelenting global competition. The depressed side is that many new challenges now face the markets: the war in Iraq, massive budget and trade deficits, and record high oil prices. Given these new challenges it is easy to see why financial markets are on edge with investors wondering which direction the markets will go. Fortunately, there are some notable bright spots:

* Housing demand remains strong and families who own their own homes have seen rapid increases in value in many markets.

* Relatively low interest rates have helped sustain the markets, particularly real estate.

The question on everyone's mind is what does the future hold?

Interest Rates

Interest rates have generally fallen for the past twenty years, due in large part to wringing inflation out of the economy. In addition, foreign governments have been buying Treasury securities to shore up their currencies, and domestic investors have been improving the quality of their portfolios in the face of erratic stock market returns. Since short-term rates have fallen much more than the long-term rates, the yield curve continues to be very steep. Historically, the spread between short- and long-term rates is a precursor to economic activity and the currently observed high spread is generally followed by an expansion and rising interest rates. Also, the Federal Reserve has been increasing interest rates in small steps to combat inflationary pressures in the economy. We expect this policy to continue and, as a result, we expect the short-term Fed Funds rate will rise to 2.75 percent by the end of 2005 (see Figure 1). Since we forecast inflation to be 3 percent in the upcoming year, the implication is that short-term real rates of interest will be negative or close to zero, which reduces the effective cost of the use of debt to the borrower. The anticipated inflation will carry long-term Treasury yields up from the current 5 percent level to the 5.5 percent range by the end of 2005. Corporate interest rates will exhibit similar increases next year. Mortgage interest rates bottomed out at about 5.25 percent last year, and we expect that mortgage rates will also rise over the next year to 6 percent. The prime rate is expected to be near 5 percent by the end of the year.

[FIGURE 1 OMITTED]

Corporate Profits

In the four quarters ending in June, the government reported that corporate profits increased by 18.5 percent, reaching a level of $876.7 billion, or 7.7 percent of gross domestic product (GDP). This is the highest profit percentage since 1966 and indicates a positive force for future growth. Corporate profits and cash flows continue to be adversely affected by high oil prices, high commodity prices for inputs like steel and copper, and rising costs of health care and pensions. These forces, along with higher interest rates, will dampen corporate profit growth next year. As the economy continues to grow (albeit at a slow 3 percent real rate), we expect corporate profits to rise only about 8 percent during 2005, less than half the rate of growth in 2004. Global competition remains fierce in virtually all markets, but the continued weakness in the dollar will help exporters remain competitive. In addition, a productivity increase of 1.9 percent will offset the small gains in labor compensation.

The weak but positive outlook for 2005 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. Unfortunately, these increases will be modest because current capacity utilization is 77.3 percent, which is below the 82 percent to 84 percent that is normally considered to be full capacity utilization. Although we see few reasons to expect a major business slowdown at this time, we also do not see a major upturn either. The recently passed American Jobs Creation Act of 2004 contains provisions that should help many manufacturing companies (broadly defined). The act includes provisions to repeal the tax exclusion for extraterritorial income (which is offset by a lower tax rate of 3 percent for domestic manufacturers), to increase the small business expensing limit to $100,000 through 2007, and to initiate a one-year tax holiday to repatriate foreign profits at a 5.25 percent tax rate. Such a low tax rate may encourage as much as $500 billion in undistributed overseas earnings to find its way back to the United States.

A major wildcard in the business sector is what corporations will do with the massive hoards of cash they have amassed. At the end of the second quarter, the Commerce Department estimated that U.S. corporations (not including farming and financials) held $1.27 trillion in liquid assets, representing 10.9 percent of GDP. This is the highest percentage since 1959. At this point, companies are very cautious in spending the hoard on capital investment or hiring until economic uncertainty is resolved. Furthermore, special accelerated depreciation allowances enacted in 2002 are set to expire at the end of the year, diminishing a tax incentive for capital spending. If corporations are reluctant to spend the money, the imperative of shareholder value suggests that the cash will likely be dedicated to increased dividends or share repurchases.

Stock Market

The best way to describe recent stock market activity is "choppy"--up, down, sideways. As the economy slowly continues to improve, we expect the stock market to also continue making gains. If corporations divest their cash hoard by paying increased dividends or buying back stock, the market will benefit. 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 to guard against too much exposure to any individual stock, market, or asset category.

Summary

The financial markets will mirror the economy--slow growth in valuations because of the global and domestic challenges outlined above. Unfortunately, it will be a bumpy ride.

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

Robert Neal Professor of Finance, Kelley School of Business, Indiana University, Indianapolis

William L. Sartoris Professor of Finance, Kelley School of Business, Indiana University, Bloomington