There's a lot of uncertainty among investors following the once-in-a-generation rally in the S&P 500 and the S&P/TSX from their panic lows set at the height of the financial crisis. What comes next?
The bears point to the extensive amount of damage that has been done to the balance sheet of the U.S. government and the U.S. dollar, not to mention the loss of wealth by the average consumer as a result of the housing debacle. There's a price to be paid, they say. And that could be rampant inflation and higher taxes.
Bulls, on the other hand, will take confidence that a recovery is under way in North America and that there is a seemingly insatiable demand around the world for resources and products.
As for the U.S., there is a growing pent-up demand for housing, the banks are rebuilding their balance sheets and an increase in savings by U.S. citizens is not a bad trend at all.
Here are five key bear and bull arguments. It's important for investors, whatever side they are on, to understand and weigh the merits of the arguments before plunking down their money in stocks or bonds.
Five reasons to be bullish:
1. Corporate profits of the companies on the S&P/500 over the next 12 months (fourth quarter of 2009 to the third quarter of 2010) are forecast by analysts to increase 27 per cent, according to Thomson Reuters, and given the ruthless cost-cutting, profits could even be higher. That suggests stocks are trading at a price-to earnings ratio of 14:1. The long-term average multiple is about 16.3, according to RBC Dominion Securities Inc.
Corporate balance sheets are in good shape. Inventory levels also remain low. "A more forceful phase of restocking seems likely to unfold over the next few quarters given that production growth had fallen so far behind consumption growth during the prior downturn," said Myles Zyblock, chief institutional strategist and director of capital markets research for RBC Dominion Securities.
2. "Don't fight the Fed." That's a commonly enough heard investment maxim. This time it is not just the U.S. Federal Reserve Board that is standing behind low interest rates. So are the G20 nations. That low interest rate environment around the world provides a lot of stimulus by enabling the battered banks to rebuild their balance sheets and it will aid the recovery of the beleaguered U.S. housing industry by keeping mortgage rates low.
So where do investors go? Equities.
"Bond returns are expected to be between zero per cent (government) to low single digits (corporate bonds) in 2010 versus 10-per-cent returns for equities," said Vincent Delisle, a portfolio strategist with Scotia Capital Inc.
3. Commodity markets account for about 46 per cent of the S&P/TSX and that's a good thing. The futures market for many commodities such as base metals are suggesting supplies will be tight and prices up, said Robert Tebbutt, vice-president of corporate risk management with Peregrine Financial Group Canada Ltd.
Although some inventories are high, the low interest rates make the cost of holding or carrying commodities extremely cheap for large financial institutions, he said. "They are saying 'We like the market, we like it now and are willing to buy now because we think prices will be higher' in the future," he said. "You must not mix it up with the situation in which speculative money pours into the markets."
Most commodities are doing well, including energy and base metals, while forest products also show signs of recovery.
"Global hedge funds and investors still believe there is good value in commodities as an 'asset class' - particularly vis-à-vis low-yielding U.S. Treasury securities," said Patricia Mohr, vice-president of industry and commodity research at Bank of Nova Scotia. "Investment funds expect restocking of basic materials across the G7, once these economies fully recover, after massive liquidation late last year."
4. Take your hats off to the indefatigable U.S. consumer.
"Despite job losses, struggling consumer confidence and the end of the cash for clunkers, U.S. consumer spending is likely to expand at about a 2-per-cent annualized rate in the fourth quarter," said Yanick Desnoyers, assistant chief economist with National Bank Financial Inc. "In other words, rising unemployment has not cut into consumer spending." National Bank estimates the U.S. economy will grow by 3.4 per cent in 2010.
5. The fiscal stimulus or infrastructure spending by the U.S. and Canadian governments is still under way, with much of the money still to be spent. And already there is speculation that the U.S. government will figure out a way of making new injections of money, perhaps using cash being returned from the banks from the Troubled Asset Relief Program.
Five reasons to growl like a bear:
1. The fragile economy is jacked up on the steroids - low interest rates and global fiscal stimulus policies. Take those away, as inevitably will happen as the world's central banks raise rates from emergency low levels, and growth will fizzle. The economy needs the private sector to pick up the slack, which depends on the willingness of companies and consumers to take on additional debt.
Cyclical recoveries can get under way while credit creation is depressed or even entirely absent, but it is difficult for an upswing to be sustained or to demonstrate any degree of vibrancy without the free flow of money and credit, said Russell Jones, managing director and global head of foreign exchange and fixed income strategy for RBC Dominion Securities. Large financial crises triggered by "housing busts" tend to leave an enduring legacy of dysfunction, he said.
So investors betting on a quick return to normalcy may be overly optimistic.
2. A weak U.S. dollar has underpinned much of the strength in commodities. It has also helped equities by improving the competitive position of U.S. exporters and bolstering the profits of the U.S. multinationals. But a stronger greenback would likely be an impediment to both groups.
A weaker U.S. dollar has been a one-way trade for months. But rising interest rates or debt problems around the world could renew the flight to safety of the U.S. dollar. Or maybe the U.S.-dollar selling is just simply overdone.
"We expect the U.S. currency to strengthen during 2010," said John Higgins, senior markets economist with London-based Capital Economics Ltd. In part, that is based on investor enthusiasm lessening for riskier assets and economies.
The dollar should also strengthen with the realization that the U.S. will not face inflationary pressures as some fear because of excess capacity preventing rising prices. In addition, while money supply has increased, the velocity of money is decreasing, he said. "We are deeply skeptical of that [inflation worries]"
3. Share profit expectations are way too high given the sluggish economy. "We would be surprised if S&P 500 operating earnings per share grew by more than 10 per cent in 2010," Mr. Higgins said. That would be considerably weaker than the over 30-per-cent profit gain being looked for by many analysts, which is typically the focus of investors. "Expectations for next year are a bit rosy in my view."
During the first half of 2010, the U.S. economy should do quite well given the fiscal stimulus and inventory rebuilding, Mr. Higgins said. "But hidden behind that is the continued weakness of consumer spending, unemployment and credit tightening constraining household spending."
While there are reasons to expect a second-half slowdown, Mr. Higgins doubts equity markets will come under severe pressure, although he expects there will be profit-taking. "The market is slightly overvalued, but we are not in a bubble."
4. U.S. households have seen their home prices drop and the value of their investments plunge, so don't count on the consumer spending to generate much growth. Those with jobs are expected to keep savings rates up to a 3 per cent to 4 per cent range from close to zero before the credit crisis. And the banks aren't in any hurry to start lending because they have to build up their reserves to withstand future bad debts from mortgages and credit cards.
5. There is always the unknown that can shock. Perhaps the hot Chinese economy, which has been a key driver of the global recovery, needs to cool down. Investors are banking on a smooth recovery. Equity option volatility is low and the spreads between corporate debt and risk-free government bonds have also narrowed back to normal levels. Of course that complacency among investors could quickly erode.
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