A nervous stock market doesn't scare George Vasic.
Mr. Vasic, equity strategist at UBS Securities Canada Inc., yesterday boosted his 12-month target for the S&P/TSX composite index by 4 per cent -- despite the index's 5-per-cent retreat over the past two weeks amid fears of a weakening U.S. economy and falling commodity prices.
Pointing instead to continued strength in corporate profit forecasts -- they expect 22-per-cent earnings growth in 2006 and another 20 per cent in 2007 -- Mr. Vasic and UBS equity index analyst Garry Cooper raised their index target to 13,250 from 12,750. They also recommended that clients increase the equity weighting in their portfolios.
"Our new target expects a TSX return of about 15 per cent from current levels, a significant premium over the 6-per-cent to 8-per-cent returns we anticipate from bonds and 4 per cent in cash," Mr. Vasic and Mr. Cooper wrote in a note to clients.
Mr. Vasic and Mr. Cooper raised their recommended portfolio weighting for equities to 55 per cent from 50 per cent, representing a medium-to-high weighting. They trimmed the cash component to 10 per cent from 15 per cent. Bonds remained at 35 per cent.
Their confidence stems from continued bullish profit expectations for the companies that make up the S&P/TSX composite. They said that, despite recent market jitters, the profit forecasts for 2006 are holding at high levels, while the 2007 forecasts have crept higher.
In an interview yesterday, Mr. Vasic played down the market's recent concerns about the U.S. housing market and its potential impact on the commodity markets and the global economy. "The fears about the U.S. housing market are overcooked," he said.
UBS anticipates a soft landing for the U.S. economy, and still expects global economic growth in 2007 of 3.5 per cent, just a shade below the long-term trend.
As a result, UBS expects global prices for most major Canadian commodities to remain steady or rise in 2006 and 2007, putting the investment bank on more bullish ground than the Street's prevailing wisdom.
In fact, Mr. Vasic and Mr. Cooper noted that their 2007 profit growth number is seven percentage points higher than the 13-per-cent consensus growth forecast. But they noted that if they were to use the consensus forecast, they would derive an index target of 12,950 -- still up from their previous target and more than 10 per cent higher than current levels.
They added that the TSX is trading at a relatively cheap 12.3 times projected 2007 earnings, further evidence that it has room to rise.
Of course, that assumes that the profit forecasts are reliable. But economists at National Bank Financial think that's a dangerous assumption.
"These valuations are only useful if analysts' projections are realistic," NBF's Pierre Lapointe and Jean-Christophe Daigneault wrote in a recent report. "History tells us that at the beginnings of slowdowns and recession, analysts tend to be overoptimistic and have a hard time predicting reversal points."
They also said that because the Canadian market isn't as diverse as its U.S. counterpart (energy and raw materials stocks make up 45 per cent of the index), and because the resource sectors are also among the market's most volatile, profit forecasts in Canada have been more susceptible to inaccuracy in the past.
They suggested that if you used a more realistic earnings target in times of economic slowdown -- the long-term trend of 6-per-cent annual growth for the TSX -- you'd find that the index has been trading at 20 times projected earnings, "a level not seen since the tech bubble."
Nevertheless, Mr. Vasic argued that with corporate profits now at such a high absolute level, they would generate 6- to 7-per-cent annual increases in book value for the TSX index even if profits simply held steady -- reason enough to predict higher levels for the index.
"The fair value of the market still rises considerably at these high levels of earnings," he said.
By the numbers
UBS target for S&P/TSX composite in 2007
Average percentage profit growth forecast by UBS for S&P/TSX companies in 2006
UBS's recommended percentage weighting for equities in model portfolio