By Darrell J. Canby, CPA, CFP^®

More than ever, predicting what will happen to the stock market is like predicting New England weather. We can see sunny skies ahead. We just don't know when they will get here.

The best way to understand where the stock market is going for the remainder of 2004, though, is to look at where it's been.

Not surprisingly, the war in Iraq has had the greatest impact on the market. During the first quarter, uncertainty about when and whether the war would begin delayed business decisions and slowed the economy. Once it was clear that war was imminent, a belief that it would be a quick war led stock prices to surge in March to their biggest weekly gains since 1982. Once the war began, the market rose and fell depending on whether the war news was good or bad.

As the war came to a quick end, though, there was no immediate bounce to lift the market. That's because Wall Street's attention turned away from the war and toward the economy, which has continued to provide its share of not-so-hot news, but with a few scattered signs of those sunny skies we mentioned earlier. There is also continued uncertainty about world affairs. The war in Iraq sent a message to Iran, North Korea and other trouble areas that the United States is not afraid to stand up to tyrants, but there are also rumblings in Syria that some fear could lead to additional fighting. The outbreak of SARS has also had a negative impact. There is also uncertainty about the fate of tax cuts that President Bush proposed to stimulate the economy.

Spending and Profits

So with the war over, what other factors are likely to impact the stock market?

Spending. Consumer spending accounts for 70 percent of economic activity, according to The Wall Street Journal, so if consumers aren't spending, the economy will remain stagnant. According to the U.S. Bureau of Labor Statistics (BLS), real earnings—consumer earnings adjusted for inflation—have increased by 3.4 percent over the past year through March, which could help boost consumer spending.

With interest rates low, consumers have been refinancing their homes in record numbers and that activity is expected to continue into the summer. Lower mortgage payments mean that consumers will have more money to spend. Tax cuts could also provide consumers with more money. But will they spend it? Did the cold, snowy winter create pent-up demand for consumer goods? Will interest rates rise, putting an end to the refinancing boom? There are no certain answers to these questions.

Businesses have delayed spending, too, but they are not likely to be in any hurry to open the corporate checkbook. With the economy in the doldrums, there is plenty of unused production capacity.

Profits. Higher corporate profits would demonstrate that the economy is growing and that cutbacks by businesses are showing results. Businesses would also have more money to spend. Profit reports have been mixed this year, but improvement could give the market a boost.

Rising profits typically mean rising stock prices, but that is not always the case. Profits from current production increased 7.6 percent in 2002, compared with a decrease of 7.2 percent in 2001, according to the BLS, yet the stock market had its worst performance in 25 years.

Interest rates. As mentioned earlier, mortgage rates, and interest rates in general, remain at historic lows. When interest rates are low, investors in search of higher returns often put their money in the stock market. Dividends from some stocks now surpass the interest rates provided by money market funds. Lower interest rates also make the cost of capital lower, so businesses can better afford to expand or invest in growth.

Production. The Euro declined in value relative to the dollar, making foreign goods less expensive and American goods relatively more expensive. As a result, imports increased and exports decreased. The trade imbalance kept growth in real gross domestic product (GDP) down to an annualized increase of only 1.4 percent in the fourth quarter of 2002, the last quarter for which statistics are available, according to the U.S. Bureau of Economic Analysis. That's an anemic growth rate that needs to improve.

Unemployment. The unemployment rate was 5.8 percent in March, and has consistently ranged between 5.6 percent and 6.0 percent since November 2001. An increase in unemployment could reduce consumer spending, but it could also boost corporate earnings. A decrease in unemployment could boost consumer spending and also would provide a signal that businesses are investing in growth again.

Inflation. Inflation remains in check. Oil prices rose at a 125-percent annual rate in the first quarter, but are already falling because the war in Iraq has ended. Oil prices are likely to remain erratic, not only because of continuing uncertainty in the Middle East, but because of political instability in the oil-producing countries of Venezuela and Nigeria. The consumer price index (CPI) rose 0.3 percent in March and is up 3.0 percent from a year earlier, according to the U.S. Bureau of Labor Statistics, but a spike in petroleum-based energy prices drove much of the increase.

Some people believe the deficit spending we are expected to experience because of the cost of the war in Iraq will put pressure on inflation. Others believe it will be offset by other factors, such as an increase in jobs and productivity. At best, it creates further uncertainty.

Lessons To Be Learned

Weighing all factors, this may be a good time to cautiously re-enter the market, or perhaps increase existing stock holdings if your portfolio is currently underweighted in stocks.

Some experts disagree, suggesting that when investors turn their attention away from the war and back to the U.S. economy, they will find the economy to be weak.

The economy could be better, but at least stocks are more reasonably priced than they have been for several years. Stocks were overpriced at the beginning of the millennium, but the market has fallen considerably since then, while recording three consecutive years of losses. The market has four consecutive years of losses an average of once per century.

Regardless of whether you decide to increase your stock holdings at this time, remember the following lessons:

Market timing doesn't work. No one knows what will happen to the market on any given day, but many investors go broke thinking they do. Invest long-term and ignore day-to-day market movement.

Dollar cost average by investing the same amount of money consistently. If you invest a large sum all at once, you might be severely affected by a bad day on Wall Street. If you invest a smaller amount consistently, you will be buying more shares when prices are low and fewer shares when prices are high.

Diversify. If you've taken all of your money out of the stock market, you will miss out on its current upside potential. If you are invested in bonds, you could experience a double whammy—your bonds could decline in value as interest rates increase, and you could miss out on an increase in stock values.

Practice asset allocation by dividing your assets between stocks, bonds, and cash equivalents, which will provide liquidity. Diversify your stock holdings by investing in small-cap and large-cap stocks, growth and value stocks, and domestic and international stocks. Your account should be reviewed periodically, and funds should be reallocated to maintain the mix.

Follow these investing fundamentals and don't worry about the short-term. Sunny skies will arrive eventually.

Darrell J. Canby, CPA, CFP^® is a founding shareholder of Canby Maloney & Company and President of Canby Financial Advisors, LLP, both of Framingham, Mass.