Last week, equities were up modestly. The Dow Jones Industrial Average climbed 0.3% to close at 10,427, the S&P 500 Index rose less than 0.1% to 1,171 and the Nasdaq Composite also increased by less than 0.1% to 2,036. There was some good news that helped sustain the markets last week. Earnings news was better than expected and we also heard a considerable amount of merger-related news- in terms of both actual deals announced and rumors. Procter & Gamble’s proposed acquisition of Gillette for over $50 billion and rumors around SBC Communications purchase of AT&T (which were confirmed early January 31) helped equity returns. About half of the S&P 500 companies have reported fourth-quarter 2004 earnings, and the trend has been that most companies have exceeded forecasts. On the negative side, gross domestic product (GDP) growth for the fourth quarter was released, and it came in weaker than expected at 3.1%, primarily as a result of the foreign trade deficit.

As we look across the economic landscape, we maintain a cautious outlook. The Federal Reserve clearly remains in a rate-tightening mode as it attempts to normalize interest rates, and such environments usually result in periods of slowing growth. As part of its effort to head off inflation, the Fed appears poised to continue raising rates unless it detects major weaknesses in the economy (which we believe are not present). This campaign of rate-tightening that started in the middle of last year has caused a flattening of the yield curve, as longer-term interest rates have remained low while short-term rates have increased.

The Federal Open Market Committee (FOMC) is set to meet this week, and it is widely expected that it will raise short-term rates another 25 basis points. The language surrounding the FOMC announcement will be carefully scrutinized. If the language is perceived as “tough,” the equity market will likely struggle; if it is perceived as allowing the possibility for some future easing, equities and corporate bonds will likely react favorably.

During most cycles of rate increases, price/earnings ratios for stocks tend to fall-and the cycle we are currently in so far has been no exception. The implication for the equity markets is that better than expected earnings growth will be needed to offset the compression in valuations. While this did occur during the second half of 2004, we think that trend is unlikely to continue in 2005, as profit margins are already at the high end of their range and labor costs are likely to increase.

An additional area of concern for us is the level of oil prices. At the beginning of this year, oil was around $40/barrel and the consensus was that prices were going to fall. Our view, as we stated before, was that oil prices were going to remain stubbornly high, given that most economies are experiencing decent growth and that spare OPEC capacity is near zero. We believe that oil prices will average more than $40/barrel in 2005, and many energy analysts and strategists also are raising their 2005 price expectations. Oil prices are part of the reason we think economic growth will be good in 2005, but not as good as consensus expectations.

Mr. Doll is president and chief investment officer of Merrill Lynch Investment Management.