MARCH 30, 2007


The case for a continued bull market

A couple of jolts have left investors shaken. Read this before you act

...and should the bear awake

by Charles Corvallis

The long bull market may well have simply suffered a couple of burps and continue to charge on. On the other hand, spring is just around the corner and there are signs that the bears are stretching in their lairs. They may well be hungry after the long hibernation that began in October 2002.

To protect yourself from being mauled — however unlikely it is that you'll come across one in your particular piece of forest — it can't hurt to take a broad look at a few industries that may perform better than others in a soft economy.

Pharmaceuticals: The industry continues to consolidate through mergers and acquisitions. Should there be a downturn these may slow but the underlying value of companies is unlikely to be affected. Though regulatory pressures on how products are marketed will continue to grow both here and in the US, the demand for pharmaceuticals is expected to increase as the population ages. Research in biologicals, vaccines and pharmacogenomics continues apace and is certain to produce marketable new products over the medium to long term. Another bonus: Pharmaceutical firms are relatively inflation proof in the unlikely event that it occurs.

Medical devices: From stents to joint replacement to artificial organs, medical devices are destined to play an increasingly important role in medicine. The industry should not be much affected by a downturn. Two companies to watch: Allergan with its devices to aid in weight loss and Kyphon, a California company that has had strong success with a device that relieves pressure on the spine. There are many others.

Other industries that can be expected to outperform the market in a slowing economy: eco-based businesses; established e-firms; coffee retailers such as Starbucks, Second Cup. Distasteful as it is, companies that pedal vice do well when others stumble: cigarettes, whisky and gambling all look like good bets.

A period of unusual calm drew to a close on February 27. That day the Chinese market dropped 9%, closely followed by sagging stock markets around the world; the TSX fell 2.7%; the Dow was off 3.3%. The sharp decline ended the second longest period in 50 years without a 2% correction and in which single day volatility had almost disappeared. If any confirmation was needed that volatility was back, investors received it on March 14 when markets were shaken. They quickly regained their composure.

The sharp break in the market seemed particularly brutal following such an extended period of calm. The correction likely reflects a long-overdue adjustment of risk premiums within capital markets — not a sudden negative turn for economic expectations. Well-executed monetary policy both here and in the US delivered an economic soft landing throughout the summer and early fall of last year. Reacceleration in the fourth quarter of 2006 initially suggested an upside risk to growth, but more recent data indicates moderation. Indications are the economy continues to follow closely along the 'path' laid by central bank planners.

I believe that going forward, stable rates point to stable growth at a moderate pace. The Chicago Fed National Activity Index (CFNAI), a weighted average of 85 monthly indicators, is now at a level consistent with sustainable growth coupled with low inflation. Further, surveys indicate that expectations of higher inflation have declined again, confirming the wisdom of monetary policy. Past soft landings have led to a period of economic expansion of anywhere from 18 months to more than six years. With stable growth and moderating inflation, the onset of the next recession may have been pushed out past this decade's end! We can only hope.

The massive stimulus given to the economy over the decade's first half has ended. Central banks now appear to be pursuing a neutral policy. Should market volatility continue, the Bank of Canada and the US Federal Reserve are less likely to launch any pre-emptive strikes on inflation by raising interest rates. That is even less likely given the fourth quarter surge we witnessed in 2006, along with the fact that inflation expectations are cooling.

Furthermore the bull market in small caps — gene-rally companies with less than $ 1.5 billion in capitalization — has pushed the Index above its equilibrium channel while much more modest gains for large caps have left the Standard & Poors (S&P) 500 just below fair value (and most of our portfolios are large cap in nature). Small caps typically lead the market through periods of surging profit growth, but year-over-year gains for S&P 500 earnings have slowed to 4.0% from double-digit levels of 2003, 2004, 2005 and 2006.

When all is said and done, the correction in equity markets and the return of market volatility likely signals a healthy reassessment of risk premiums, not a negative swing in the economic outlook or a fatal blow to the bull market.

Here are four promising things to keep in mind when considering your portfolio:

  • Economy is growing at a moderate pace.
  • Inflation, and more importantly inflation expectations, are moderating.
  • Hikes in short term interest rates are unlikely.
  • Large cap stocks as a group appear to be priced below fair market value.

Charles Lasnier is an Investment Advisor with RBC Dominion Securities Inc. [email protected].

This article is for information purposes only. Please consult with a professional advisor before taking any action based on information it contains.





back to top of page




© Parkhurst Publishing Privacy Statement
Legal Terms of Use
Site created by Spin Design T.