(01/20/12) 2012 from the Great White North

In the simplest terms, it looks like this is shaping up to best described as another “buckle your seatbelts” year, writes Tom Slee of The Canada Report.

Welcome to a new year where, as usual, we face a mixed bag. There is a European downturn underway, US growth remains anaemic, the crucial Chinese economy is slowing, and most commodity prices are weakening. That’s a substantial hill to climb.

On the other hand, there are some promising signs. We go into January with record corporate earnings, lean balance sheets, and low borrowing costs. Moreover, companies are awash with cash and stocks remain relatively cheap.

It all points to a bumpy year...but there are going to be some excellent investment opportunities.

First though, we should take a quick look back at 2011. It was disappointing. After a promising start, we ran into all sorts of difficulties and the Canadian stock market ended the year down.

As a result, my forecast of a modest 8% gain for the S&P/TSX Composite proved far too optimistic. After touching a high of 14,329 in April—very close to my 14,500 target—the Toronto market headed south, plunging 18% from its peak.

Investors became alarmed by the sagging US recovery and continuing European debt fiasco—so much so that by August the VIX, our famous “fear index”, had jumped to 50. To put that into perspective, the VIX has averaged 28 since the crash in 2008.

In the end, the TSX finished December at 11,927, down 11% for the year. In New York, the S&P 500 at 1,257 was essentially flat for the period.

The problem was that the US economy—which was showing signs of life as 2010 ended—stalled. This made all the difference. Investors would have been far less concerned about the turmoil in Europe if the US and Canadian recoveries had gained some traction. Any possible banking contagion would have seemed manageable.

Instead, people became discouraged and the VIX remains at a disturbingly high 35. Investors are highly defensive, and we are no longer seeing upward pressure on interest rates in the bond market. As you may recall, I was expecting to see ten-year US Treasury notes yielding 4.25% and ten-year Government of Canada bonds at 4% by the end of 2011. Instead they are paying 1.9% and 2.1%, respectively, and the central banks are firmly committed to keeping a tight lid on interest rates, short and long.

Now for the hard part: what can we expect in 2012? To a large extent it’s going to be more of the same, and three things in particular worry me.

First, it looks as though the all-important US economy will continue to move sideways, with GDP expanding at about 1.5%, the same as last year, and well below 3% in 2010. The recovery continues to sputter. Here in Canada, we are likely to grow at 1.8%, down from an estimated 2.3% advance in 2011.

Second, there is a possibility that the euro will be significantly devalued, a move that would spur the European economies and ease the sovereign debt problem. It would also make North American goods expensive and torpedo our stock markets. My feeling is that it’s unlikely to happen because devaluation sparks inflation, Germany’s greatest fear. Nevertheless, if there is any discussion of a cheaper euro, we should reassess our investment strategy.

Third, the earnings backdrop is losing strength. Corporate profit growth slowed last year. In late 2010, more than 80% of S&P 500 companies were beating expectations. By the third quarter of 2011, the rate was down to 70% and many CEOs were issuing pessimistic forecasts. Profit margins are starting to shrink.

There are, however, some positive signs. Basic investor sentiment is improving, if only because people are becoming immune to the doomsday news from Europe. Even the media, distracted by the US Presidential election, is losing interest in Greek debt.

As a result, investors are more likely to focus on business news than dramatic sound bites in 2012. That would give the markets more stability.

I also think that US and Canadian stocks are cheap. The TSX revised earnings for 2011 have a near-historic low 14.47 multiple. Applying the same factor to forecasted 2012 earnings of $920 gives us an S&P/TSX Composite of 13,312 at the end of this year.

As far as interest rates are concerned, it seems almost certain that the central banks will orchestrate the markets. So it will be mostly sideways movement. The US Fed Funds rate of 0.25% is likely to remain unchanged, while ten-year US Treasury notes, currently yielding 1.9%, are expected to inch up to about 2.25%.

Also, I think that the Bank of Canada’s overnight rate of 1% is going to remain unchanged, while ten-year Government of Canada bonds could move up from the current 2.1% yield to around 2.5%.

As you can see, there are a lot of cross currents. We are going to see feeble economic growth, flat interest rates, some earnings growth, a continuing debt crisis, and political uncertainty. At the same time, Chinese demand may be much stronger than expected and most major companies are in excellent shape.

So, as I mentioned, it’s likely to be a bumpy ride in 2012, but some stocks will perform well.

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