Strong C$ enhances U. S. market’s appeal
U.S. stocks
have been a
disappointment the past
five years. For
Canadian
investors, the
strengthening
of the loonie has rendered returns from the U.S. equity market even more miserable. Canadian investors have done well on the home front recently. But should they reconsider U.S. stocks for better diversification, given that there is now no foreign content limit in Canada? Will the U.S. dollar weaken further and hamper returns to Canadians? If you are tempted to do some cross-border equity shopping, what kind of returns can you expect? Sonita Horwitch and Buy and Sell took these questions to a team of five leading money managers. Q: What’s your outlook for the U. S. equity market? Hensen: The S&P 500 index, the benchmark U.S. index, will likely produce high single-digit returns per annum going forward. Year to date, it has recorded low single digits. There is a 1.7% dividend yield on the index and an expected long-term profit growth of companies in the index of about 6%. We are looking at an 8% total return per annum. We do not expect an expansion in the valuation, i. e., the P/E multiple. There is risk that the P/E multiple will contract further. We are in an environment where the U.S. Federal Reserve Board has been increasing interest rates. If you look back as far as the 1960s, there were 11 periods of sustained Fed tightening and the 12-month stock market return following those periods was flat. We do not envision a hard landing for the U.S. economy. The U.S. consumer is healthy, corporate profits are strong, balance sheets are strong, the companies are generating a huge amount of cash flow and productivity levels are high. Once the Fed finishes raising short-term rates, historically you have seen low double-digit returns on the S&P 500 index. What will be the impact of the higher cost of energy on the economy? It has clearly impacted the low-income U.S. consumer. Some of the retailers aimed at this market are showing weakness. But generally, it looks as if the consumer is going to weather this. With all these positives, you might ask why the S&P 500 index is only up 1.4% year to date. Blackstein: But there are a lot of stocks that have done very well. Hensen: The Value Line Index, an equally weighted index of just under 1,000 companies, including U.S. mid-cap and small-cap stocks, has been doing well. It is testimony to the health of the smaller cap stocks. The S&P 500 has been in a period of P/E multiple contractions since December, 1998. We were at 1236 back then, we are near there today. The valuation on the index has gone from a P/E multiple of 27.5 times to around 16 times 2006 estimates, a contraction of 43%. At the same time EPS are 70% higher. I do not expect P/Es to expand. Myszkowski: If you take a look at what has been going on in the U.S. equity market over the past several years, especially in the large-cap growth stocks where we operate, it has been tough to make money if you have not been in a sector or two. We are in the fifth year of sideways movement, the Standard & Poor’s peaked in the fourth quarter of 1999/ first quarter of 2000. We are looking for a catalyst to get the process moving again. Hurricane Katrina will be another drag on U.S. stock prices. Chris, we are probably in the same kind of total return range that you are — high single digits, that was my estimate at the start of this year and is unchanged. Over the next couple of years, it is really going to be a stock pickers’ market. This old cliché is right. This is not going to be a market that you can just jump into. O’Reilly: The key to the global economy is what is happening to the U.S. consumer? We have been expecting weakness here for some time and have not seen it. Manufacturing wages have been growing by 2.5% versus the headline CPI index, which is in excess of 3%. The short end of the yield curve has risen, but the long end has come down. This has been supportive of the U.S. housing market. Americans have a high marginal propensity to import goods and that supports the rest of the world, which has been doing very well on the back of the U.S. consumer. The big risk is if the interest rate curve at the long end starts moving up in response to potentially higher inflation numbers. We are seeing pricing pressure coming through in various areas. Offsetting this is the cheaper products from China sold to the rest of the world. As a global investor, the U.S. equity market has been my less preferred over the last five years. It has nothing to do with the quality of U.S. companies, which set the high watermark throughout the world. We look to buy companies that are better than the stock market thinks. Looking at relative values, we have found that there are better opportunities outside of the United States. The question is when will the U.S. equity market acknowledge that profit growth will continue? Blackstein: Investors looking to retire in the next 10 or 15 years are making a catastrophic mistake avoiding the United States. There is no global health care industry that can rival the United States, which has the greatest depth and breadth in this sector. Canada has few health care companies. There are some European health care companies like Roche, which I like. The best thing about Roche is that it owns Genentech Inc., a biotech company in the United States. In the technology sector, there is no Google anywhere else in the world. There is no Apple Computer Inc. outside of the United States. Q: What about the vulnerability of the U. S. dollar over the longer term? Myszkowski: Fed chairman Alan Greenspan wants to keep inflation as low as he can and he is raising short-term rates. In the short-term, I think that the US$ is going to fall but will stabilize longer-term. As long as the Chinese continue to finance the trade deficit at 3.5%, then it is fine. Blackstein: The Canadian dollar has been rising against the US$ because the Canadian dollar is viewed as a petro-currency. The call on the Canadian dollar vis a vis the US$, is essentially what your call is on energy. Hensen: A plus is that the U.S. budget deficit, also a focus of international concern, has actually come down from US$420billion to US$310-billion. O’Reilly: The concern on the U.S. balance of payments front, is if the Chinese stop buying U.S. treasuries in a meaningful way. They have already started diversifying their holdings. I think that the U.S. dollar will depreciate over the next 18 months. This is not to say that the euro or the Japanese yen are such great places to be. Q: Let’s go back to the U. S. equity market. The big cap S&P 500 has done poorly, but the mid-caps, represented in the S&P 400, have done well. Rhonda? Chang: The cycle for mid-cap outperformance began in March, 1999 and the S&P 400 index’s total return since that time to the end of August of this year is 108.9%, compared with the S&P 500 total return of 4.6%. The mid-caps produced better earnings growth in that time period — up 96% compared to the large cap companies, which grew their earnings by 38%. As Chris mentioned earlier, there was some P/E multiple contraction in the large-cap universe, which we did not see in the mid-caps. So for the mid-caps, it was a combination of better earnings growth and maintaining their valuation metrics that produced better performance.