A combination of profit-taking and renewed interest rate jitters moved the market into negative territory during the first two weeks of the year.

After the run up in share prices following the November 2nd election, it looks like large institutions (pension funds, mutual funds, hedge funds) have now decided to nail down their profits. Specifically, portfolio managers have spent the first few weeks of the year selling off the volatile technology and small-cap stocks that had exploded higher during the year-end rally.

The published minutes of the Federal Reserve's December meeting on interest rate policy also put the markets on high alert. The minutes revealed that some Fed members fretted about inflation and even considered removing the word "measured" to describe the anticipated slow and steady pace of future rate hikes.

The Fed has used the word "measured" to describe the likely pace of future rate hikes often throughout the past year, and investors feared that a change in policy here could signal an era of rapidly rising interest rates, which would weigh on corporate earnings and drag down share prices. However, a closer reading of the minutes suggests the markets may have overreacted, since the minutes also indicated most Fed members expected inflation to remain low.

The S&P 500 Index (^GSPC, 1184.52) fell -2% in the first two weeks of volatile trading action. Dividend-paying stocks, as measured by the newly expanded Dow Jones Select Dividend Index (^DJJ, 697.90), followed the S&P 500 into negative territory and are now down -3% in the year-to-date period.

REITs, which last year posted almost three times the gains of the broad-based S&P 500, also came under selling pressure. The benchmark Morgan Stanley REIT Index (^RMS, which we will now be tracking in lieu of the smaller Dow Jones Equity REIT Index) plunged -4% after the Federal Reserve's inflation concerns were made public. That was the sharpest one-day drop the index has seen since last April. RMS closed Friday, January 14th at 722.28, down -6% since the start of the year.

The steep decline may present entry opportunities for select REITs, some of which should be nicely cushioned from rising interest rates. In forthcoming issues of our High-Yield Investing newsletter we will keep readers abreast of our latest findings in this high-yielding corner of the market.

OUTLOOK
The big question is whether the latest downturn in stocks represents a short-term correction or a longer-term trend.

Historically, the market has an equal probability of going either higher or lower. Of the 20 times in the past 75 years when the market closed down the first week of the year, the market ended the year lower 10 times and higher 10 times, according to Stock Trader's Almanac.

Looking ahead, the Federal Reserve is widely expected to raise short-term interest rates another 25 basis points (0.25%) at their next policy-setting meeting on February 2nd. At this point it remains to be seen whether the Fed will also signal that future rate hikes could be faster and larger than originally expected. Such a move appears unlikely given the host of conflicting economic reports in recent weeks, as well as current projections for an economic slowdown in 2005.

As earnings season moves into full swing, fourth-quarter 2004 earnings reports and corporate outlooks for 2005 will drive the markets throughout the next few weeks. S&P 500 companies are still expected to report healthy +15% to +18% growth in fourth-quarter earnings. And even though earnings growth is expected to slow to a single-digit pace in 2005, that still leaves room for stock prices to rise.

Whatever direction the market takes in the near-term, we fully expect to see continued volatility in the coming year. Given the mix of unclear economic news, unstable oil prices and an uncertain U.S. dollar, going forward we likely will see a repeat of the roller coaster pullbacks and short-lived rallies of 2004.

Long-term income investors should have no trouble taking the market's ups and downs in stride. Although the S&P 500 may take one step backward for every two steps forward, nevertheless, for reasons we described in our January issue of High-Yield Investing, we believe the index will end the year about +8% ahead of 2004 -- and +10% ahead when you include the impact of dividends.

Judging by the opening weeks of trading, large-cap stocks, many of which pay dividends, are on track to outperform small-caps this year. While the S&P 500 Index of the 500 largest stocks trading on U.S. exchanges has lost just -2% so far this year, the Russell 2000 Index (^RUT, 617.48) of the 2,000 smallest publicly traded U.S. companies has already given back more than -5%. It appears institutional investors have been dumping their small-cap holdings but keeping their large-cap stocks -- a move that bodes well for income investors.

In this environment of single-digit growth and rising interest rates, investors will need to work diligently to uncover quality stocks with solid growth prospects and secure dividends. As usual, we will continue to keep a close watch and alert readers to entry opportunities in fundamentally strong, yet currently undervalued, income stocks. With this in mind, in our February issue of High-Yield Investing we will take an in-depth look at a few carefully selected stocks in sectors that we feel are poised to post the strongest gains throughout 2005.

Important Note:  To view the remainder of this article, in which Carla Pasternak provides an in-depth analysis of her three model income portfolios and dozens of individual income-oriented investments,  you'll need to subscribe to our premium High-Yield Investing newsletter. After you subscribe you'll receive immediate access to the remainder of this article, as well as our semimonthly High-Yield Investing newsletter and a host of additional premium content. Please visit one of the following links to continue...

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