Look back to see ahead in the stock market

By Dan Richards and Marc St-Pierre

 

 

 

It's never different!

 

In these pages last October 14, we made the case that the stock market was poised for recovery

and that investors who could stomach some short-term ups and downs would be rewarded for

their patience. Our commentary was accompanied by a contrasting view which argued that stocks

were still overvalued.

 

No one could have foreseen the roller coaster ride that followed. Significant gains in the last three

months of 2002 were followed by retrenchment in the first quarter of 2003, and then strong

performance in the past six months. For the 12 months ending September 30, the Canadian

market gained 22%. The broad U.S. stock market was up 24% – or 6% when expressed in

Canadian dollars, reflecting the soaring loonie.

 

So, where do we go now?

Many observers remain cautious about equities. They note that valuations in some sectors,

particularly technology, are reminiscent of the late 90's mania. The quagmire in Iraq is

contributing to record U.S. budget deficits. There is concern that many major corporations must

top up significantly under-funded pension plans. There is concern too about the ability of North

American companies to meet new, low-cost competition from China and India.

A longstanding axiom holds that investing's four most dangerous words are "It's different this

time."

 

The most apparent danger is that this declaration can encourage money-losing speculation. For

example, in the late '90s those who questioned the wisdom of pouring money into stocks with

unprecedented valuations and concepts with little promise of profitability were repeatedly told "it's

different this time."

 

The less obvious danger is the cost of opportunities that are missed by overlooking the lessons of

history. Many of the issues which worry market skeptics are real. Yet if you look back, every point

in time had both good news to fuel optimism and bad news to cause concern. All that varied was

the view investors chose. When stocks are peaking – as in 2000 – investors focus on good news

and ignore the bad. When they are bottoming – as in 2002 – investors are oblivious to positives

and consumed by negatives.

 

We believe some commentators are now painting an unduly negative picture. We are, on

balance, positive about the period ahead - for three fundamental reasons.

 

Increasing profits

 

First, corporate profitability. Profits ultimately underpin the direction in which the stock market

moves. Fueled in part by low interest rates and easy money policies at the central banks,

corporate profits are recovering all over the world: from North America to Europe to Japan.

Importantly, U.S. companies are starting to increase capital spending, restoring the capacity and

inventory they worked down over the past few years.

 

Forecasts suggest third-quarter profits for the U.S. companies in the Standard & Poor's 500 index

will be up 15% from last year, and fourth-quarter profits will be up 21%. While these gains have

already been largely factored into stock prices, a growing number of companies are beating their

forecasts and show earnings momentum going forward. Skeptics may say rising earnings won't

offset today's negatives because this time it's different. We say it's never different; profitability

always matters.

 

Productivity growth

 

Second, prospects for productivity growth. Companies are now reaping the payoffs from record

investments in technology that were made in 1998 and 1999, driven largely by concerns about

Y2K. Today's hyper-competitive marketplace and relentless focus on driving down costs are

pushing productivity even more, leading to the much publicized "jobless recovery" in the U.S.

A strong case can be made that innovation and rising productivity will continue to fuel economic

growth. Some feel this time it's different, that rising productivity is killing too many jobs. We

suggest it's never different; productivity growth is a positive for stock prices.

 

Low interest rates

Third, inflation and interest rates. Interest rates reflect the outlook for inflation. We believe both

will remain low.

Low interest rates are extremely positive for stocks. They encourage economic demand among

both consumers and companies by making borrowing more affordable. Plus, they boost

valuations for the profits that result from increased sales as demand grows.

The price paid for a company's stock reflects that organization's earnings both today and into the

future. Future earnings will be worth more if inflation is low than if it is high. Wouldn't you pay

more for something that's likely to be worth $100 in five or ten years than something that's likely

to be worth $75? So would other investors.

That's why, historically, low inflation and low interest rates have increased the multiple the market

pays for a dollar of future earnings. Skeptical commentators miss a key point when they say

today's market is overvalued because the price/earnings multiple is now above average. This

multiple is not overvalued if you look at periods with comparable inflation and interest rates. Is it

different this time? We say it's never different; low inflation and low interest rates always matter –

a lot.

 

All this does not mean a return to the late '90's when investors could buy stocks indiscriminately

and reap double-digit returns. What it does mean is that stocks will offer attractive returns relative

to bonds and cash for those who follow a disciplined and broadly diversified investment approach,

who can accept volatility and who avoid getting swept up in the market's periodic excesses.

That's what happened in the past, and it's not different this time.

 

Dan Richards is Chief Executive Officer and Marc St-Pierre is Chief Investment Officer of Cartier

Partners Financial Group.