Market Could Switch Horses in Midyear

Last year was a winner for stock investors. And some of 2003's top performers have started with a bang this year.

But will the same stars shine throughout 2004? And where will investors find more gains?

Some market pros with good track records predict there will be two stories in 2004. In the first part of the year, some of the same stocks that ruled the roost in 2003 will continue to lead the way. That group includes technology stocks such as Intel (INTC) and Yahoo (YHOO), as well as cyclical and small-company stocks.

But as the year wears on, the rally could run out of steam, as interest rates edge higher and investors acknowledge that much of the market is quite expensive. That could lead to a shift to more stable, safer stocks, including companies such as Microsoft (MSFT), Japan's Sony (SNE in U.S. trading) and Washington Mutual (WM).

"I think 2004 is a year of sector and market-cap leadership shift," predicts James Paulsen, chief investment officer at Wells Capital Management.

Last week, despite stumbling Friday following disappointing job data, the Dow Jones Industrial Average managed a 0.5% rise. The Nasdaq Composite Index, chock-full of tech stocks, rose 4% for the week, leaving it with a more than 87% gain since Oct. 9, 2002.

The week saw huge gains for some stocks that soared in 2003, such as Lucent (LU) and Nortel (NT). The Dow Jones US Technology Index is 5.7% higher in the young year. These types of stocks kept climbing for the same reasons they surged last year: Rising global growth, expectations of an uptick in U.S. business spending and an embrace of risk by investors. For now, those market underpinnings aren't going anywhere.

As a result, a sharp selloff is unlikely, at least in the near term. But the job of the investor is to take the long-term perspective. And 2004 is unlikely to mark a second year of dominance for riskier tech shares.

Little Room for Error

For one thing, many of these stocks already are expensive. And with their high prices, they leave little room for disappointments in earnings. Because second-half earnings will be measured against the improving earnings witnessed in the last six months of 2003, it will be harder for these stocks to impress Wall Street.

At the same time, interest rates likely will move somewhat higher, as growth stays strong and investors start fretting about inflation. Few economists expect a marked rise in rates, but investors should brace for the impact of even a slight increase. Any such movement could lead to a re-examination of all kinds of risky positions on Wall Street.

As a result, some say the second half of the year will mark a comeback for high-quality stocks, including larger companies and those that pay juicy dividends. Some recommend that investors turn to companies that show strong profits and a history of increasing their dividend payments, the kinds of stocks that didn't keep up with the averages in 2003. The reason: As taxpayers prepare their 2003 returns in the spring they will focus on last year's dramatic dividend-tax cut and begin to focus on these stocks.

"In 2004, the focus will return to companies that pay high dividends, as investors focus on quality again," says Michael J. Napoli Jr., managing director at Wilshire Associates, the Santa Monica, Calif., investment-advisory firm. Some analysts recommend Washington Mutual, which has a dividend yield of about 3.5%.

"Beginning the year, I believe the same leadership of 2003 will be in force for 2004," Mr. Paulsen says. "However, as the year progresses and the economy gets stronger, ultimately it will bring talk of Fed tightening. I expect sector leadership to change toward defensives and larger-cap stock indexes."

Mr. Paulsen is a fan of large tech companies, which should benefit as companies upgrade computers and increase their overall tech spending after three years of pent-up demand. Others say technology stocks with steady earnings, such as Microsoft, will fare better than upstarts that soared last year despite puny earnings.

Ready to Spend

"Business spending is about to turn up," predicts William Miller, the superstar mutual-fund manager at Legg Mason Inc. Mr. Miller likes InterActive Corp. (IACI), a collection of Internet shopping sites.

Mr. Paulsen also likes large manufacturing companies that export their products and can benefit from the weak dollar because it allows them to export their products more cheaply.

Here's a sleeper pick from Mr. Miller: Eastman Kodak Co. (EK), which has been in the doghouse amid the shift by consumers toward digital camera technology but still boasts dependable sales from its traditional film business.

If we do see a slight rise in interest rates, as the bond market begins to anticipate a move by the Federal Reserve to raise rates in 2005, financial stocks could suffer. For now, there are no signs that inflation is returning. And Friday's employment report is a reminder that the economy still has its problems, suggesting the Fed won't act soon to raise rates. But as the year progresses, rising rates likely will become a bigger worry. That could hurt some financial stocks, such as Citigroup (C) and J.P. Morgan Chase (JPM), later this year, some say.

"Financial stocks, which have benefited from lower interest rates, are especially sensitive to a tighter monetary policy," says Sung Won Sohn, an economist at Wells Fargo Bank.

What stocks and sectors do you think will lead the way this year? Write to: forum.sunday03@wsj.com

Updated January 11, 2004