Advisors proceed cautiously as interest rates rise and the dollar falls.

    In many ways, last year's fears have become this year's realities. As 2004 began investors wondered whether the long-awaited bear market breakout could possibly continue after a year in which the S&P 500 Index had risen 26.4%, and the Nasdaq vaulted 50%. Energy prices were creeping up and the dollar was sliding, but the continuation of those trends was far from certain. And while whisperings of inflation filled the air, interest rates seemed to be comfortably mired at historically low levels. 

    As this year begins, higher energy prices and a falling dollar have matured from worrisome anomalies to what some believe could be potentially long-lasting trends. Despite some post-election euphoria, stock market returns that were generally listless for most of 2004 have paved the way for modest expectations this year. And interest rates, particularly at the shorter end of the yield curve, are moving up again.

    Against this backdrop, financial advisors positioning client portfolios for 2005 are tweaking their strategies to adjust to the economic and market environment, and to their own expectations about where markets are headed. To the advisors interviewed for this article, the threat of inflation and a meandering stock market portend lethargic or possibly negative returns in the coming year.

    "The year after a President is elected for a second term has historically not been a good one for stocks," says Ronald W. Roge of R.W. Roge & Company in Bohemia, N.Y. "I'm assuming single-digit returns for the equity and fixed-income markets."

    High on his list of concerns is the budget deficit, which he fears could nudge inflation higher. "The country can either tax its way out of a deficit or inflate its way out," he says. "I think there is a higher probability of inflation than a tax increase."

    Although Louis Stanasolovich of Legend Financial Advisors in Pittsburgh expects low single-digit returns from the stock market over the long term, he feels that 2005 is shaping up to be a year of retrenchment. "As the Fed raises interest rates, stocks could be viewed as relatively expensive. We could see returns at the negative teens level," he says.

    Not all advisors share that view. Michael Weber, principal of Weber Financial Services in Green Bay, Wis., believes that now that the Presidential election is over, the stock market will have "fewer distractions and will be able to get down to business. But there won't be a return to the 1990s bull market. I'm looking for stock market returns in the 5% to 7% range over the next decade."

    Although Weber expects modest returns from stocks this year, he still thinks they will outperform bonds, and he plans to increase his exposure to U.S. equities slightly in the coming months. "If we have a portfolio with 40% U.S. equities, we might go to 45% or 50%," he says.

    Other advisors expect to make more noticeable shifts. Roge says his portfolios this year will have more of an international flavor than they did in 2004, a reflection of the dollar's continued weakness against the euro and other foreign currencies. The widely held expectation for a further fall in the dollar was reinforced late in the year, when the greenback dropped to an all-time low against the European currency. (A record number of investors are also scouting opportunities overseas. According to AMG Data Services, international stock funds received nearly $43 billion in inflows through the end of October, eclipsing the previous record of $34 billion for all of 1994.)

    Over the next six months, Roge plans to step up his firm's equity allocation to international funds to a maximum of 50%, up from 25% at the beginning of November. His portfolios are overweighted in funds that invest in small and mid-sized international companies because they do business in their local economies and are more immune to the ravages of a weaker dollar than larger companies, which derive much of their revenue from sales in the United States. Funds on his list of favorites include Julius Baer International Equity and Artisan International Small Cap.