Last year was so easy. OK, not if you were laid off, or trying to stem losses at an honest-to-goodness business. But forinvestors, 2009 couldn’t have been simpler. After all, as long as you were in the market, you made money. Even the worst stock pickers among us cleared a 20% return. Index investors made 35%. Easy.
Here’s a prediction you can bank on: the rest of 2010 will not be easy. It may surprise us, on the upside or down, but few will be able to say they saw it coming. Since the beginning of the year, there has been no consensus on the Street, with the markets about evenly populated with bulls and bears and various critters in between. That’s probably a good thing; it’s when almost everybody is looking in the same direction that things tend to go badly. Our very vigilance to risk factors reduces the probability of being broadsided by something like the Lehman Bros. insolvency that triggered the crash.
But what happens next? There are convincing scenarios from both sides. The bulls see a year of growth and relative prosperity. Their argument is grounded in the fact that the world’s major stock markets hit a historic low in March of 2009, following the largest decline since the Great Depression, and that both economic indicators and corporate profits have improved substantially since then. Nations around the world seem to have succeeded in co-ordinating interest-rate cuts, stimulus spending and bailouts of strategic firms. Oil prices have more-or-less stabilized at a level that encourages new production without crippling the economy. Historically, such recoveries have been the time to invest in equities.
Moreover, this recovery seems stronger than most. “These are the fattest profit margins coming out of a recession in the U.S. in 40 years,” observes St?fane Marion, chief economist for Montreal-based National Bank Financial. “Valuations right now are not excessive. What was excessive was the sell-off we had last year.”
Today’s powerful inventory-rebuilding cycle – demonstrated by Canada’s five consecutive months of manufacturing output increases – is the result of 20 months of pent-up demand, Marion argues, and any stock exposed to that rebound will benefit. He believes the markets will receive another boost once the U.S. recovery is confirmed with positive job creation. (That day might be at hand. U.S. Department of Labor stats showed 162,000 new jobs were created in March, after 25 months when private-sector payrolls dropped by 8.3 million.) Nobody expects a repeat of last year’s performance, but bulls like Marion anticipate a decent year of low double-digit returns.
The bears, by contrast, tend to focus on three things. First, a rally in stocks that has run ahead of even the improving fundamentals. In the 12 months to March 9 of this year, the TSX/S&P 60 had rebounded a whopping 52.5% (57% factoring in reinvested dividends). Good as they are, Canada’s economic indicators aren’t that good. As UBS analysts remarked in their second-quarter report, global equities are now “past the sweet spot.” When you compare current stock prices in Canada and the U.S. to 10-year average earnings, both markets are already looking downright expensive.
Second, the bears see any number of possibilities that could push the global economy off the rails. As Gary Chapman, managing director at Guardian Capital LP in Toronto, puts it, the path ahead for finance ministers and central bankers “is like walking a tightrope,” with precipitous falls on either side. So far, they’ve managed to keep their balance, but the odds are against their going the distance without a stumble.
Among the obvious threats is mounting government debt, which at best will result in higher or more pervasive taxation and/or lower public-sector spending. “The markets are very likely not taking into account the extent of the fiscal tightening that is going to be required over the next three to five years, which will undoubtedly have a dampening effect on everything from income to spending to output to profits to inflation,” David Rosenberg, chief strategist at Toronto’s Gluskin Sheff + Associates, wrote in his daily blog in April.
At worst, the debt binge could result in sovereign debt defaults, which may prove hard to contain, given the staggeringly high debt-to-GDP ratios in several countries. (Although Canada is not in that group, as a trading nation it would be substantially affected.)
Underlying these fears is the failure to correct international trade and current account imbalances that many economists believe were the real cause of the recession. Americans have yet to reverse their trio of trade, current account and fiscal deficits, while the main beneficiary of that unsustainable regime, China, has so far refused to devalue its currency relative to the U.S. dollar.
The third looming hazard cited by the bears relates to interest rates, which have nowhere to go but up. In Canada, rates higher than the “free money” available in 2009???10 are a virtual certainty. Already, inflation figures are edging up, and commercial banks have begun raising five-year mortgage rates, which will likely dampen an admittedly frothy housing market.
Not only are there big risks on the horizon, the progress of the recovery is less impressive than it first appears, argues Rosenberg. “The Canadian economy is still digging itself out of a big hole, and it is not just about growth but also about levels of economic activity. The reality is that real GDP is still about 2% lower today than it was at the cycle peak 18 months ago,” he says.
“We’re at a funny juncture. What is the next phase?” muses Leo de Bever, CEO of Alberta Investment Management Corp. (AIMCo), one of the country’s largest capital pools. While he agrees that stock markets have seen “too much too soon,” de Bever’s hunch is that there could still be more gains ahead. Most industries are not operating at anywhere near capacity; that can be a good thing, because existing plant, equipment and other assets are not as well allocated as they could be. New, more efficient capacity is being built, he reasons, which in the course of time will result in higher productivity and sustained growth.
In the meantime, companies and industries with pricing power on their side will fare the best, the obvious choices being food, materials and energy. In a controversial value play last year, AIMCo offered a $380-million debt-and-equity lifeline to Precision Drilling Trust, Canada’s largest oilfield services firm, which paid off handsomely (though the fund manager’s top five common equity holdings are all banks). De Bever has longer-term hopes for the green technology sector, too. To date, it has been a great big money pit, but he believes it will eventually produce a shift comparable to the one around 1900, when electricity and internal combustion replaced coal, wood and whale oil. “It may be a tough slog for equities at least for the next six months or so,” de Bever warns. But further out, he sees progress. “Five years from now, we will look back on this as a really bad dream and we will have moved on.”
Moving on, however, likely does not mean enjoying the returns investors grew accustomed to in the 1980s and 1990s. In his book Stocks for the Long Run, Wharton finance professor Jeremy Siegel notes that the average real total return of the U.S. stock market between 1982 and 1999 was 13.6%, what he calls “the greatest bull market in stock market history.” That’s exactly double the 6.8% real return for the 204 years between 1802 and 2006. Going forward, even expecting the latter return may be optimistic. “The U.S. is headed for a period of slow growth,” says Guardian Capital’s Chapman. “The U.S. consumer has seen the ghost of leverage past. They’ve realized they can’t retire based on their house prices. They’ve got to save more, and they’ve got to do it in a low-interest-rate environment.”
While debt can boost earnings for a while, a number of studies have pretty conclusively demonstrated the correlation between GDP growth, corporate earnings and investment returns over the long term. And GDP growth is determined mostly by two things: population growth and productivity increases. The aging populations of the developed world, coupled with the need to reduce debt levels in both the private and public sectors, suggests muted economic growth ahead. “Over the long run, investors should expect real returns on common stocks to average no more than about 4%,” wrote Bradford Cornell, a professor of financial economics at the California Institute of Technology, in Financial Analysts Journal earlier this year. “Moreover, this result holds for the entire developed world, not just the United States.”
Even the bulls have some longer-term caveats on this count. National Bank’s Marion expects a slowdown in economic growth around 2014???15, when OECD countries finally stabilize their debt-to-GDP ratios and begin to confront their demographic challenges. “Down the road, there is no escaping the reality of the numbers,” he says. But for now, “the cyclical upswing will more than offset the structural challenges.”
Others dismiss the this-time-it’s-different talk. “I don’t believe we’re in a new era in any way, shape or form. I don’t think investor psychology really changes,” says Benj Gallander, Toronto-based portfolio manager and publisher of a newsletter called Contra the Heard. “Where I do see a difference is in the nature of time.” The glut of information available to investors has sped up the pace of market moves without making them any more intelligent, Gallander says. “It wouldn’t surprise me if cycles move more quickly now.”
Canadian markets, skewed as they are toward the energy and materials producers most influenced by Chinese demand, are likely to benefit from this reconfigured world economy. However, accepting the hypothesis is one thing; having the courage to buy on those convictions is another. Dom Grestoni, senior vice-president of Winnipeg-based Investors Group and manager of its Canadian Large Cap Value Fund, bought heavily into Teck Resources when almost everyone else was selling the stock last spring. When it rebounded in spectacular fashion, the stock grew to 20% of the fund. Though he’s since sold it down to 14%, Grestoni thinks the miner still has upside. He feels the same way about long-lived energy plays and fertilizer producers. Moreover, as China’s economy shifts to focus more on internal demand, Grestoni sees opportunities for infrastructure players such as Bombardier and SNC-Lavalin.
Though he’s likewise convinced of the Asia-ascendant theory, Chapman, who manages Guardian’s Canadian Equity Growth mandate, warns against going too heavily into commodity sectors. He prefers to counterbalance the resource sector with diversified growth stories: Gildan Activewear, with its debt-free balance sheet; pipe manufacturer Shawcor, for its market dominance in corrosion-resistant pipe; and Research In Motion, whose bandwidth efficiency will come to the fore with the rising demand for wireless video.
Even if policy-makers continue to get it right, Chapman expects the overall market to end up flat for the year. Hence, “It becomes a matter of stock picking.” See? Not easy. On the pages to follow, you’ll find the essential data and insights on Canada’s largest 500 public companies to get you started.
