Analysts square off on market movement

(July 8, 2005) In the wake of an equity market run-up over the past three years, many investors are starting to get nervous. Will the markets continue to recover, or will the rally fizzle out?

Subodh Kumar, chief U.S. investment strategist at CIBC, is considered bullish. He says the current valuation of 18 to 20 times earnings for the benchmark S&P 500 is reasonable, considering the market’s position in the current business cycle.

“Earnings in the first two years since 2002 were well above expectations, as typically happens early in the cycle, and that now we’ll be below expectations and might peak in the middle of next year,” Kumar says. “But it’s still too early to worry about a peak right now.”

Many investors seem to believe the cycle is winding down and that earnings will soon peak. Kumar says he does have lower earnings expectations than many of his colleagues for the coming quarters, but that he believes they will strengthen after that.

He predicts a dip in earnings on the S&P 500 over the coming two years, but a recovery by 2008.

“You can say that 1,500 in 2008 versus 1,527 in 2000 means we are in a secular bear market,” he says. “But in 2000 the markets were way too high and that’s where relative factors come into play.”

On a 20-year basis, which he says is more appropriate for measuring secular trends, the rise from 278 in 1988 to 1,500 in 2008 represents a 9% annual rate of return. Looking at the rate of return simply from the most recent bottom of 777, gives a total rate of return of about 13% over the past five or six years.

“I think that the next phase that we will see is going to be back and forth movement between value and growth and the differentiator will be the quality of delivery of individual companies,” Kumar says. “After five years of value outperformance, quality growth and delivery by companies is going to be more important and probably drive markets higher.”

He thinks these quality companies can be found in healthcare, consumer staples, defence and info tech. He also believes financials have been oversold.

Kumar says stock market performance in the 1990s distorted what people considered to be appropriate returns. He expects returns of 5 to 6%, but admits that as the cycle ages, returns will become more volatile.

“I think the 1970s, 1980s and into the 1990s were extraordinarily volatile decades and that we are now in a more ‘normal’ environment, if anything can be called normal,” Kumar says. “I believe inflation is less of an issue than it was in previous decades and that puts less pressure on the central banks.”

Myles Zyblock, chief institutional strategist and director of capital market research at RBC Capital Markets, seems to agree with Kumar. Except he is considered a secular bear.

“I think that total returns for the stock market are going to pale in comparison to what we saw in the 80s and 90s.” he says. “I think buy and hold or passive strategies are something in the past and that tactical or rotational approaches to the stock market will provide much better returns. The key really is stock selection.”

He advocates a concentrated portfolio, since there is little point trying to match an index that is going nowhere. “The last thing you want to do in the coming decade is mimic the market.”

Since 1956, Zyblock says the annual rate of return has been about 10.5%, but that over the past decade, valuations have become stretched. Assuming valuations contract to where they were just 10 years ago, Zyblock says that will result in total returns of about 2.7% for the next decade.

“If you say the stock market is inexpensive, I think that’s what a behavioural finance guy would call a framing bias,” Zyblock says. “We’re inexpensive relative to our peak in 2000, but we’re not inexpensive, relative to 100-odd years of history.”

Zyblock describes the RBC model portfolio as being overweight on equities, but points out that fixed income is even more overpriced than the stock market. In fact, the bubble in U.S. Treasuries poses one of the biggest threats to equities.

“Historically the stock market gets into the most trouble, both in Canada and the U.S., when the U.S. yield curve inverts — we’re not there yet,” says Zyblock. “I think the natural tendency of the stock market is to want to go up, but go up at a slower rate. For me the smoking gun is the yield curve.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/08/05)

Steven Lamb