I've no doubt that Apple are/have been working on touch screen devices of many sizes and resolutions. Bringing a 5" device to market next year on the other hand, is pure speculation.
The best case I've read for a size between 3.5" and 9.7" is the 163 story, linked to by Gruber on Daring Fireball. iPad Mini [or whatever] around 8" would scare Amazon & other Android tablet producers to bits if it came in at the right price
Amazon and other Androil tablet producers wouldn't be scared. They would run for their money if 8-inch iPad is possible and priced at $299. I think Apple can make this device and successfully out compete the competitors in that category. Imagine the current iPad 2 is shrunk to 8" screen. Would anyone buy other 7" tablets if 8" iPad 2 is available now at $299? I doubt it.