Simon Avery
Globe and Mail Update Last updated on Monday, Oct. 05, 2009 01:48PM EDT
There is a nervousness around the markets this week as a rising chorus of experts questions whether seven months of rapid gains in the stock markets have essentially been driven by government spending.
To calm those fears, companies are going to have to deliver solid results during the parade of third-quarter earnings that kicks off this week. Without that injection, the markets are going to falter, economists warn.
“The consensus view is that we're in for a tepid economic recovery, leaving the recent run-up in stocks with what many view as an unjustifiably high valuation,” Robert Kavcic, an economist with BMO Nesbitt Burns Inc., writes in a report entitled Can Stocks Earn Their Keep? “However, equity market valuations are hardly stretched, and as we head into the [third-quarter] earnings season, the recovery in corporate profits has the potential to surprise to the upside.”
Among the positive factors he points to is aggressive cost-cutting by companies. U.S. businesses, for example, slashed compensation almost 7 per cent in the second quarter. In addition, just as consumer prices are down this year, production costs are also lower. Add to that a lower U.S. dollar, and companies south of the border have the potential to post strong profitability.
“The recent rally in equity markets has been built largely on expectations of a recovery in corporate profits. While the consensus view on the economy seemingly argues otherwise, there are mounting signs that the earnings recovery could be on the strong side” Mr. Kavcic wrote.
The economist also points to the spread between the 2-year and 10-year U.S. Treasuries, which is at 2.7 percentage points, its steepest since at least 1980. A steep yield curve between the two can bode well for the economy and adds to banks' profits, he said.
Companies' ability to boost profitability in this economy will prove key to the market's performance, experts say. “The economic recovery may be sub-par, but the leverage on corporate profits may still positively surprise,” says Vincent Delisle, strategist with Scotia Capital.
While there is always the chance of a double-dip recession, investors can best protect themselves by overweighting cyclical stocks. Mr. Delisle picks the Americas and emerging market exchanges over those of Europe and Japan. In terms of sectors, at the moment he favours U.S. energy, materials, discretionary, financials and technology.
Stock markets could post returns of between 10 per cent and 15 per cent in the next 12 months, compared with low single-digit returns for government bonds and cash, he forecasts.
Investors need to adopt a tactical approach in current conditions, rather than a long-term, buy-and-hold view, he advises in a report.
The stock markets got a positive jolt from earnings results for the previous quarter, when share profit was better than expected. But this round, expectations seem to have risen higher, leaving less room for positive surprises, writes Peter Buchanan, an economist at CIBC World Markets Inc. As one indicator, he notes that more than half of all analysts' earning revisions for the third quarter have been upwards, a figure which is higher than usual.
Among the economic news putting pressure on the markets: Job losses are up, while sales of previously-owned homes and orders for manufactured goods are both down. The unemployment rate in the United States hit its highest point since 1983 last month at 9.8 per cent. Rising joblessness and falling disposable income is hurting consumer confidence, economists say.
“Real GDP growth likely turned positive again in [the third quarter], but the path out of recession will not be smooth so long as the outlook for U.S. consumer demand remains week,” wrote Meny Grauman, an economist with CIBC World Markets Inc.
It's not clear yet how much consumer spending has been propped up by government support, principally the “cash-for-clunkers” auto incentives in the United States. “The real barometer of the American consumers lies in the labour market,” Mr. Grauman said.
Statistically, summer stock market gains are followed by October weakness. The 10 per cent jump on the Toronto Stock Exchange ranks 10th best since 1956 and compares to a median gain of only 1 per cent. But the probability of the market rising in October after a strong summer is only about 35 per cent, writes George Vasic, a strategist at UBS Securities Canada.
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