Financial forecast.

• Author: Neal, Robert S.

The financial outlook for 2003 is cautiously optimistic. We think the market has reached its lows and is now poised to return to the positive column. As we all know too well, since peaking in March of 2000, the performance of the equity markets has been abysmal. The Dow Jones 30 Industrials has fallen 24 percent, the S&P 500 has declined 41 percent, and the Nasdaq Composite has plummeted a stunning 73 percent. As investment professionals who advocate a long-term investment strategy, we have suffered the decline with everyone else. In fact, our 401k plans have been reduced to 301k's!

From a historical perspective, the behavior of the markets over the last seven years has been highly unusual. From 1995 to 2000, the S&P 500 increased an average of 21 percent per year, well above the long run growth rate of roughly 11 percent. These growth rates, of course, are not sustainable. Many have characterized this period as a "bubble" and indeed, after the fact, the description seems appropriate. However, suppose that as a long-term investor you had put your money in the S&P in 1995 and not paid any attention to the markets. Your average return over the seven-year period would be 7.5 percent per year. That's a bit lower than the historical average, but still a decent overall return.

As students of financial markets, we know that stock prices are influenced by three fundamental factors: interest rates, earnings, and attitudes toward risk. Our outlook toward interest rates is generally favorable for the next year. While interest rates are at historically low levels, the market does not expect a large increase over the next year. The Federal Funds rate--the interest rate set by the Federal Reserve for very short-term borrowing--is currently 1.75 percent, an extremely low interest rate. Does this mean that interest rates will rise in the near term? In fact, the opposite is expected to occur. The interest rate on short-term Treasury Bills is now about 1.5 percent. The only way for the Treasury Bill rate to be below the Federal Funds rate is for investors to expect the Fed to announce additional rate cuts in the near future.

A different logic applies to long-term interest rates. The ten-year rate is currently about 4 percent, also at the bottom of its historical range. Do we expect this rate to rise? Yes, but forecasting long-term rates is a bit like forecasting next year's Super Bowl Champion--a very imprecise process. Long-term interest rates are driven by...