Top three stock picks from RN Croft’s Richard Croft

Richard Croft is president of RN Croft Financial. His focus is on options and ETFs

TOP PICKS

National Bank

National Bank follows the theme of buying Canadian banks to take advantage of an expansion in their net interest margins. Higher interest rates are actually good for these securities.

Wells Fargo (Jan 2015 42 calls)

Leveraged way to trade a U.S. bank. WFC is number one in terms of mortgage originations for residential properties. Buying $42 (U.S.) strike calls that are in-the-money provides investors with an opportunity to leverage their participation to this sector with limited risk.

Horizon BetaPro S&P/TSX Capped Financials Bull Plus

Same theme but with leveraged exposure to the Canadian financial sector. Given the challenges with leveraged ETFs this should be a shorter-term trade looking to exit the position by the end of the first half of 2014.

Past Picks: July 30,2013

Bank of America (January 2015 15 calls)

Most recent purchase July 24-2013 @ US $1.994

Then: $1.79; Now: $2.15; Total return: 20.10 per cent

Toronto Dominion Bank (January 2015 90 calls)

Do not own calls but own TD stock

Then: $4.75; Now: $9.10; Total return: 91.6 per cent

Manulife Financial

Most recent purchase July 8-2013 @ US $17.81

Then: $18.2;5 Now: $20.75; Total return: +15.30 per cent

Total return average: +42.33 per cent

Market outlook:

T.I.N.A., which stands for "There Is No Alternative," has become a perverse acronym used by analysts on both Bay and Wall Street to explain the seemingly unstoppable rally in stocks globally. Despite a serious slippage in the metrics – i.e. revenue, earnings, price to earnings - that typically propel stock values, major global markets have been riding a wave of liquidity. Canada being the notable exception to the rule!

Global sentiment is clearly bullish and based on the low volatility numbers coming out of the options market, traders are not the least bit apprehensive. That leads us to the central theme that equity markets supported by positive sentiment are climbing a wall of worry. A very steep wall considering the fickle nature of sentiment and lacklustre performance of liquidity infused economies!

Canada has been the poster child of how real economies recover from a deep recession. Slower than normal growth to be sure! But an undeniable positive trend rooted in a solid banking system and real consumer demand. Far removed from the steroid-driven economies – notably Japan, the European Union and the U.S. - that are clearly overdosing on liquidity!

In terms of real economic activity, Canada's GDP grew at an annual rate of 3.5 per cent year-over-year to September, 2013. Not bad considering that the U.S. economy did less than that despite three versions of quantitative easing. The one troubling area being Canada's exports which fell in September. Could that be an early warning sign of an impending U.S. slowdown (Canada's largest trading partner) as the Fed begins to taper?

That is the major question facing Canadian investors as we enter 2014. Like it or not we are linked at the hip to our U.S. cousins and a slowdown south of the border will affect Canada. It is a question of degree!

There are signs that the U.S. economy is slowing based on some of the revenue warnings being issued by S&P 500 companies. Slowing growth already impacted the just-completed third-quarter revenue numbers. While many U.S. companies were able to beat the bottom line, that had more to do with margin expansion driven by productivity improvements and share buybacks. Manipulative metrics that can benefit over the short term but longer term distort reality.

More to the point, neither of these metrics will likely provide much support in 2014. Companies are being less aggressive with their share buyback programs and productivity has gone about as far as it can before companies have to embark on major hiring programs. The problem for North American companies is their reluctance to do anything amid so much uncertainty. Think about health-care costs, tapering and politicians who simply cannot get out of the way.

So far the only resolution to come out of Washington was bi-partisan support for an increase in the debt ceiling in exchange for an agreement to agree about a tax-and-spending debate at some point in the future. In short: nothing that will improve visibility or instill confidence. Without that, bulls need to have faith that markets will continue following the path of least resistance in much the same way as avarice relies on the "greater fool theory."

Still I am reminded of an old saying attributed to Sir Winston Churchill where he said – and I am paraphrasing - that the "U.S. tends to do the right thing… eventually." I too believe that U.S. politicians will do the right thing… eventually. But in the interim, investor emotions will be subjected to a tsunami of political grandstanding that will cause short term sell-offs, spikes in volatility and perhaps one could argue, longer term gains.

With that in mind, investors might want to focus on Canadian stocks through the first half of 2014. Better to watch the political performance from this side of the 49th parallel. At least you have a buffer against a shift in sentiment caused by political tremors.

I am cautiously optimistic that the second half of 2014 will provide some signs of real economic growth. Any sign of a U.S. recovery – regardless of size – without any serious inflationary concerns would boost Canadian stocks.

I also think Canada will play catch up to the U.S. (note: Canadian stocks have lagged U.S. stocks for the past two years) as Canadian sectors leveraged to the U.S. recovery would likely out-perform the broader U.S. market. Canadian stocks could rally on the back of P/E expansion related to potential revenue and earnings growth while U.S. stocks simply hold their ground as economic reality catches up with hyped optimism.

Ripe for the picking in this environment are Canadian exporters, transportation companies and financial services. Enbridge, TransCanada Pipelines, Canadian National Railway and Canadian Pacific could turn in some decent numbers in 2014. Even without that, blue chip Canadian names may be less risky as rich dividend payouts provide a homemade put option that can limit the downside.

On the other hand I am not enthused about commodity-based stocks like Agrium and Potash, energy companies such as Suncor and gold miners like Barrick, Goldcorp and Agnico-Eagle. Part of my concern is the lack of inflationary pressures which are key drivers for commodities, energy and most certainly precious metals.

Canadian banks are interesting from a couple of perspectives; 1) I expect them to be front and centre during any economic recovery and 2) they benefit from a steepening yield curve. We know that rates will continue to rise as tapering gets priced into the market. And we know that higher rates are toxic for long term bonds and without any hint of inflation pose a significant threat to real return bonds.

More importantly higher rates create a serious problem for conservative portfolios that typically hold a sizable bond weight. The takeaway; clients who need a fixed income allocation need to shorten their duration which dampens return or augment their bond portfolio with some dividend paying Canadian banks.

And there's the rub! We are witnessing a marked shift in risk metrics where bonds may carry greater risk than equities. As we have been saying… There Is No Alternative to stocks.