Don't miss the market upswing

Expect a market surge as high as 9%.

(Ilustration: Ryan Inzana)

Four years after the worldwide stock market crash, fixed income still rules. The vast majority of investment money continues to flow into supposedly crash-proof bond funds. According EPFR Global, a company that tracks worldwide fund flows, almost US$480 billion went into fixed income funds in 2012, while nearly $80 billion was withdrawn from equity funds. That’s despite record low interest rates, which have made it extremely difficult to make money in the bond market, and stock markets that have seen a big surge since 2009.

This is a case, a growing number of market experts agree, where the herd is clearly headed in the wrong direction. For Richard Przybylski, president and chief investment officer with Stylus Asset Management, the stock market is already the better place to be and will do better still as the tide turns. Most investors, though, won’t get back into equities until it’s too late. “People tend to invest as if they were driving their cars using their rear-view mirrors,” he says. “People are getting out when they should be getting in.”

One reason to look at equities, he says, is that they’re relatively cheap. The S&P/TSX composite index currently has a price-to-book ratio of 1.48 times versus its historical average of 1.65. Canadian companies are also offering an average net return on equity of 4.53%, much better than the historical norm of 2.55%. Stock yields are attractive too. A 10-year Government of Canada bond pays around 1.8%, while the S&P/TSX composite’s yield is around 3%. Improving economic conditions, such as rising U.S. house prices, retail sales and employment numbers also suggest that seeking safety in bonds may be not be as necessary as it was.

So why aren’t more people buying stocks? They’re likely waiting for some big move, says Kim Shannon, president and chief investment officer with Sionna Investment Managers. We’re currently in a sideways market, she says—one marked by volatility and years of both high and low returns. It’s the kind of environment that spooks investors; it’s hard to know which way the market is going. Sideways markets typically last about 15 years, and we’re in year 12, she says. When it’s over, the market will enter a bullish phase as investment capital washes back into stocks. As a result, she predicts returns should rise significantly over the next decade.

In the meantime, gains won’t be too shabby, either. Shannon says the Canadian market could return between 6% and 9% in 2013. Studies have shown that, in sideways markets, the average total return of the S&P 500 is about 6%. Canada often does better than other countries under such conditions because commodities tend to rally. So add a little extra to the average and we could see an 8% or 9% return. Shannon thinks that investors do realize that equities are better than fixed income over the long run, but until they see proof of a roaring market they’ll keep waiting. “Investors will probably miss some of the easy money,” she says. “That’s how investors are.”

Bruce Cooper, TD Asset Management’s vice-chair, thinks another reason people are sticking with bonds is that the fixed-income market has seen middling to high single-digit returns over the past decade as interest rates came down. Cooper thinks that high sovereign debt levels will keep interest rates depressed for a while. Only now, with nowhere for yields to go but up, investors will be lucky if they get a 2% return on their bonds, he says. Equities, though, are not only appreciating in value—most of the world’s stock markets were up last year—but dividends are boosting portfolios too. The S&P/TSX composite, a relative laggard, ended 2012 with a 4% gain, but its total return topped 7%. Of course, there will still be volatility. But it’s hard to argue that returns won’t be better in the years ahead.

For investors who are planning to get back into the market, the best way to get a return of between 6% and 9% is by finding cheap buys in the market with strong earnings, says Przybylski (see our recommendations in “The CB Hotlist” to the left). He avoids companies that have seen earnings fall in the past year or that have missed analyst estimates. He’s also wary of businesses that have seen future earnings forecasts revised downward by analysts. “Long-term investments are companies with good top-line revenue and sales growth, and if that’s not happening, then leave,” he says.

Shannon tries to be as diversified as possible, and she seeks undervalued stocks that pay a dividend. She’s also a big believer in reversion to the mean, which is one reason why she sees opportunities in the natural gas sector. With gas prices so low, it’s only a matter of time until they rise. Having little or no debt is also important; the cleaner the balance sheet the better a company will be able to deal with short-term market volatility.

Gibboney Huske, a fund manager and vice-president at Legg Mason Capital Management, suggests looking at consumer discretionary stocks that have exposure to the improving U.S. housing market. Home prices were up about 5% year-over-year last fall, and many expect those gains to continue into 2013. She also thinks brand-name consumer staples companies with exposure to emerging markets will have a good year. There’s still domestic consumption growth in places like China, India and Brazil, she says. Huske is also digging into some cyclical sectors in the hopes of finding more long-term names. For example, in the tech sector, she’s looking at companies that provide cloud computing, something she thinks most companies will adopt in the future. “Cloud computing is less dependent on a strong economy, and we want to find growth outside of the normal cyclical cycles,” she says.

If you’ve been thinking about wading back into stocks, now’s the time. Don’t be the last person to get in. Przybylski is already hearing from some who think they’ve missed the boat and say they might as well stay in bonds. “Are you kidding me?” he asks. “Yes, the sale started 12 months ago, but the sale’s not over. People say they can’t invest now because all the opportunities are gone. It’s not true. They’re just looking for a reason to stay out of the market.”

The CB hotlist

WestJet Airlines Ltd. (TSX: WJA)
P/E: 12.8 | Yield: 1.59%
1-year total return (C$): 75.14%
For investors who want to add some kick to their portfolio, consider this Calgary-based airline, says Stylus manager Richard Przybylski.

Aimia Inc. (TSX: AIM)
P/E: 18.78 | Yield: 4.14%
1-year total return (C$):
This Montreal-based company (formerly Groupe Aeroplan) manages loyalty programs for airlines, car companies, tech firms and more. It offers both income and value, says Przybylski. It has little debt, and it has increased its dividend three times in the past two years.

Steward Information Services Corp. (NYSE: STC)
P/E: 16.2 | Yield: 0.37
1-year total return (C$):
This Houston-based firm provides title insurance to home buyers around the world. Its exposure to the U.S. real estate market makes it a winner.

Granite REIT (TSX: GRT.UN)
P/E: 26.27 | Yield: 5.1%
1-year total return (C$): 26.8%
This Toronto-based real estate trust used to be known as MI Developments, Magna’s real estate arm. It’s now independent, though its former parent still provides 97% of its rental revenue.

P/E: 14.89 | Yield: 1.42%
1-year total return (C$): -22.87%
Calgary-based CNQ is Canada’s No. 2 natural gas producer, as well as an oilsands producer. When gas prices rise, which Sionna Investment’s Kim Shannon thinks they will before long, it will get a big boost.