Inflation Separates Bulls and Bears on Wall Street

WSJ.com - Wall Street's Crystal Ball Reveals an Overcast 2005

Question of the Day: How will the Dow industrials perform in 2005?

The Bull:

Oak Associates
Edward Yardeni, chief investment strategist
Akron, Ohio
S&P 500: 1385; DJIA: 11700
Fed-funds rate: 3%
10-year Treasury yield: 4.5%
Dollar: The euro at $1.45 in the first half
"The most critical element of my forecast is my very benign outlook for inflation," writes Mr. Yardeni, who predicts inflation as measured by the consumer price index will hold steady at around 2% -- for the rest of the decade.
That's some forecast; he offers several reasons to back it up. The end of the Cold War and China's admission to the World Trade Organization accelerated globalization, he argues, spurring the integration of national markets around the world. That development acts as a catalyst to free trade, which helps keep down inflation through increased open competition.
In other words, writes Mr. Yardeni: "Prosperity, like love, conquers all."
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The Bear:

Bank of America Securities
Thomas McManus, chief investment strategist
New York
S&P 500: 1200
Mr. McManus, one of the few 2005 bears we surveyed, thinks stocks have gotten too pricey relative to earnings. That makes them a risky bet heading into a year that will likely see rising interest rates, he says. Today's stock valuations "overlook the significant rise in inflation expectations," writes Mr. McManus.
Inflation isn't going to creep -- it's going to jump right in our faces, he says, since "we're going to see a plethora of rising prices" in the first several weeks of the year.
Investors have become overconfident, says Mr. McManus, and are ignoring a number of risks. Part of that overconfidence stems from the fact that P/E ratios, while high by some accounts, are still well off their historic highs. The operating P/E ratio of the S&P 500 companies currently is at 21.02, compared with 46.05 in December 2001. But as inflation ramps up, companies will have trouble maintaining their profit margins, he says, and that could hurt P/Es.
Copyright WSJ 2005