America on the rebound

With so many investors fixated on day-to-day market fluctuations, it’s easy to forget that the S&P 500 is back to where it was before the financial crisis. Since prices bottomed on March 6, 2009, the benchmark index of America’s large-capitalization companies has climbed an astonishing 110%. It was up about 15% in the first nine months of 2012 alone. The rebound has helped rebuild many investors’ portfolios, including those of Canadians whose domestic stocks have lost money lately. While the S&P/TSX composite index is up 62% since March 2009, over the past two years it has fallen about 8%.

Every Canadian investor should have some part of their portfolio in U.S.-based stocks. Three sectors—financials, energy and materials—make up 76% of the Canadian index, so if you want to own underrepresented sectors such as technology and health care, you need to look south of the border. Advisers typically recommend putting 50% of an equity portfolio in Canadian companies, 25% in American businesses and 25% in international operations. Given the global outlook, some experts are now suggesting an even higher allocation to U.S. stocks.

With the Canadian energy sector’s volatility likely continuing in 2013 and worries that our increasing personal debt levels will affect our financial sector, it’s likely the S&P 500 will outperform our market for the third straight year, even if returns there are moderate. Bob Gorman, chief portfolio strategist with TD Asset Management, thinks U.S. markets will post gains in the mid-single digits in the new year. “That’s not inconsistent with what we’d see at this point in a recovery,” he explains.

Sam Stovall, S&P Capital IQ’s chief investment strategist, also thinks the market will see a more modest increase in 2013. He thinks the S&P 500 will hit 1,525 by the end of next year, which would be a 6% increase from where the market was in October 2012. But make no mistake; this market has room to grow. Stovall points to the “rule of 20,” a calculation many people use to determine the S&P 500’s valuation. Take the price-to-earnings ratio and add the rate of inflation. If the number equals 20, the market is fairly valued. If it’s less, it’s undervalued, and if it’s above that number, it’s overvalued. “It’s been pretty consistent since 1948,” he says.

With the S&P 500’s trailing P/E at 16.3 and inflation at about 2%, the number stands at 18.3. “The implication is that it should be trading at about 10% higher than where it is now,” he says.

If Gorman and Stovall are right, a Canadian investor could just buy an S&P 500–tracking exchange-traded fund (ETF) and see some nice gains. But more savvy buyers might want to look at some specific sectors for even greater upside. Christian Correa, a portfolio manager with Franklin Templeton Investments, says housing-related industries and companies could be big winners next year. U.S. housing starts are steadily climbing— the rate of home construction is up about 60% since it bottomed in April 2009—and that trend isn’t expected to reverse. Home prices are also rising, which suggests more people are buying again. Because of the improving housing data, many home-building companies have seen valuations rise. Correa sees better opportunities in businesses that have exposure to the real estate market, such as Wells Fargo, which is a leader in the mortgage industry. The company will benefit in two ways, he says. First, the more people buy houses, the more mortgages it will sell. Second, it will be able to make more money on its foreclosed homes if housing prices keep improving.

Gorman points to Home Depot as another company that could see its profits improve along with the housing market. It doesn’t depend on just home building. It also makes money from homeowners who may now have a little more cash to fix up their abode. “It is, to a great extent, a reflection of consumer confidence,” says Gorman. “It speaks to the willingness to spend money to improve the family home and to consumers feeling better about things.” Technology is another sector to consider. Gorman, Correa and Stovall all think it will do well next year. The industry’s cheap, trading at around 10 times earnings, and it has a lot of growth potential. Look at companies in the computer software sector, says Gorman. These businesses bring in recurring revenues, which makes them more stable than the hardware companies. Stovall likes the sector because, he says, in a weak economy, executives prefer to expand their operations by upgrading their computer systems rather than by increasing the head count.

Other promising sectors include financials and heath care, says Gorman. The former should improve as the economy strengthens and people regain confidence in the banking system, while the latter will benefit from the aging population profile, emerging-market demand for drugs and changing health-care rules.

It’s also likely 2013 will again be the year of the large-capitalization, dividend-paying stock. While the large-cap-tracking Russell 1000 index was outperforming the small-cap Russell 2000 index by 1.5 percentage points in October, Stovall thinks that, with bond yields so low, more money will continue fl owing into big business. There is talk of U.S. politicians raising the dividend tax rate next year, but that won’t deter income seeking investors. “Even if the tax rate becomes equivalent for dividends and bonds, you’re still getting more from dividends,” he says. “Baby boomers nearing retirement will still be looking for good income.”

Gorman agrees. Large caps are still cheaper than small caps—the Russell 1000 has a P/E ratio of 15.3 versus 17.2 for the Russell 2000—and, these days, a dividend payout seems more dependable than growth. Large caps are also more consistent earners and, generally, better diversified than their small-cap counterparts. “Large caps will continue to be the best spot from a risk-reward standpoint,” he says.

While the U.S. market has improved from both a price and valuation perspective, Correa says there are still plenty of good opportunities for investors. “We’re pretty excited about U.S. equities in general,” he says. “You can still find high-quality global companies trading at 10 times earnings, and with the economy improving, there are a lot of things to feel good about.”