A Tougher 2004?

Well, well, well. How was 2003, fellow investors? Nice, wasn't it?

The year was relatively easy for buy-and-hold types, especially those who owned Nasdaq issues, as that market jumped 40%. The economy rebounded from 2002 lows, the housing market remained strong all year, and interest rates stayed low. Stocks were driven on expectations of an economic rebound, and when that surfaced, by a bounce in earnings.

Five months of rising equities started to make investing seem simple, but then the markets -- especially the Nasdaq -- went choppy, reminding us that it's not that easy. The good news was out. Investors had anticipated it with a long ascent. And now 2004, in my opinion, will likely be much more challenging for stock buyers.

Next year, we should continue to witness a steep drop in home refinancing (so stocks of related companies should suffer); we're almost surely going to see a slowdown in new home starts after record highs throughout this year, putting home builders and related companies on shakier foundations; and we're likely to see interest rates begin to rise by summertime, causing some investors to move toward interest-bearing vehicles and away from stocks.

With gains in interest rates, rate-bearing investments offer better competition against stocks for investment dollars. Next year, we're apt to see this battle begin, especially if the Federal Reserve raises rates as many as four times, as some already predict.

Throw in the fact that year-over-year growth comparisons will be much tougher in 2004, and we're entering a year that will probably present shareholders with many more challenges than 2003. The rebound surge that lifted most stocks happened this year. Next year's gains are likely to come much more selectively.

I suggest this not because I own a crystal ball (although I do own three, one with a nice teal glow) -- but because it's simply how the tea leaves are reading. Even as most companies predict the economic rebound to continue, the question for stock buyers is: Which equities will continue to participate at market-beating rates?

First, we're due for a review.

Reviewing 2003 stocks
With a wish to put something on the line early this year, I shared several of my stock picks and pans (most from this year, one from three years ago) that I felt strongly about, and promised we would track them. It's time again.

The stocks are Intel (NASDAQ:INTC), eBay (NASDAQ:EBAY), Lance (NASDAQ:LNCE), Pepsi (NYSE:PEP), Mellon Financial (NYSE:MEL), LendingTree, Home Depot (NYSE:HD), Johnson & Johnson (NYSE:JNJ), and, on the "pan" side, AT&T (NYSE:T) and McDonald's (NYSE:MCD).

First, let's consider the "picks."

Focusing on business quality and valuation (yuppers, even with eBay), while measuring against opportunity, has lent itself to topping the market's return. This basket of stocks gained an average of 64% against the S&P 500's average 20% gain -- so, we achieved greater than three times the market's return. Plus, I don't believe this group of mostly large caps involved great risk.

Only one stock lost money, and one other lost to the market, but neither were great surprises. Covering J&J and Pepsi in March, I wrote that J&J looked fully priced and could lag a while. Now that it's at 18 times 2004 estimates, yields nearly 2%, and fetches 18 times forward free cash flow, it's more attractive.

Here's how the two "don't buy 'em" pans performed.

My belief that debt-ridden McDonald's would not turnaround this year was incorrect. The stock is up 48% since I wrote a column originally titled Steer Clear of McDonald's. While I wouldn't sell short a monster like McDonald's unless bankruptcy loomed, I steered investors wrong by suggesting to avoid the Golden Arches.

Avoiding AT&T has been a better call, and I believe will continue to be.

Overall, it was an excellent year for this collection of stocks, and -- keeping humble and cautious -- for the market as a whole. The year had me buying a few other stocks, too, including Netflix (NASDAQ:NFLX), Meridian Biosciences (NASDAQ:VIVO), and speculative MRV Communications (NASDAQ:MRVC). And I continued to sell options (selling puts), primarily for income.

(In the last 15 months, I've made 24 "put" option sales. Twenty have been profitable, with an average gain of above 90%. Four sales were losers, with an average loss of 26%. When you sell an option for income, your ideal outcome is that it expires and you pocket 100% of the price (or premium) you were paid to sell it. Your second ideal is that the stock falls to your desired price and you're "put" the shares, which later rise again. Given the success I've had with this strategy in good markets and bad, I plan to continue employing it cautiously in 2004 and writing about it more often.)

Looking to 2004
We're in an environment of deficit government spending, increasing money supply, expanding gross domestic product, and a declining dollar against major currencies. This could suggest inflationary pressures around the corner, which then implies rising interest rates. In turn, rising rates suggest a slowdown in the housing and mortgage market, and a reallocation of some capital away from equities. (Historically, the higher interest rates go, the lower the average P/E on the stock market. The inverse is true the lower rates go, because investors are then willing to pay up for a return in stocks.)

Few people expect interest rates to rise tremendously in 2004, though. It's an election year and the administration will do everything possible to make it a positive one for the stock market and the economy in general. But we're at 40-year lows in rates, and rates move in cycles, so the trend is going to turn and likely bring about a long cycle of rising rates, with initial increases almost assuredly beginning next year.

For this reason, I'm looking for a few stocks that will benefit from rising rates -- aside from the usual issues like Paychex (NASDAQ:PAYX) and Automatic Data Processing (NYSE:ADP) -- and avoiding stocks are that will be harmed by rising rates. I'm also looking at weaker housing market companies to consider shorting.

I also believe there are shorts to be found in smaller companies that soared this year and are now overpriced, especially in technology and biotechnology. But as always, my main focus -- as should be the focus of most investors -- is finding excellent stocks to purchase and ideally hold.

Some companies I'm watching closely are high-growth XM Satellite Radio (NASDAQ:XMSR), whose product is excellent, long-term business model looks promising, and (I believe) they know what they're doing financially; AtheroGenics (NASDAQ:AGIX), a revenueless speculation that has a promising drug in phase III trials; J2 Global Communications (NASDAQ:JCOM), a high-growth stock that was recently halved to an interesting valuation; and Eastman Kodak (NYSE:EK), where Legg Mason's famous money manager Bill Miller has taken a massive 12.5% stake, saying the price is beaten down too much (it was nearly cut in half this year, too).

Overall, 2004 promises to be more challenging than this year (and I think we've seen the start of this during the last few months), so investors should begin the year with balanced portfolios, believing in what they own and the valuations at which they're holding. Meantime, making new purchases will present greater challenges. A lot of value has been rooted out this year, so good opportunities are much scarcer -- but new ones will present themselves, and it'll be a pleasure to find them.

I wish you a prosperous -- and, more than that, happy -- 2004!

Seeking stock ideas for 2004? The Motley Fool's Stocks 2004 offers 11 investment ideas from Fool analysts, including one from Jeff Fischer.

Jeff Fischer bought his first stock the day after Black Monday in 1987. He sold it the next day. (Kidding.) He's a longtime portfolio manager and analyst at the Fool. Of stocks mentioned here, he owns many -- all shown in his profile. He can be reached at [email protected].