Contributing editor Tom Slee joins us this week. He has been surveying the turbulent investment horizon and has some suggestions for readers as we look ahead to 2015. Tom managed millions of dollars in pension money during his career and is also an expert in taxation. Here is his report.
Tom Slee writes:
Investors are nervous as we head into 2015 and who can blame them? October's correction came as a cold shock, which is putting it kindly. Chicago's Volatility (VIX) Index, the "Fear Factor", soared to a three-year high and the rebound failed to reassure people. The plunge in the price of oil further unsettled investors.
Yet most of the important signs remain positive. North American markets are likely to perform well in the year ahead, led by consumer rather than resource stocks because of a fundamental shift that is now underway. The vast U.S. economy is finally flexing its muscles and relegating China to second place as a market factor. I think that's encouraging. I also think it means U.S. equities will outperform their Canadian counterparts.
For years the Chinese "miracle" has hypnotized us. So much so that Britain's prestigious magazine, The Economist, recently published a model that shows China becoming the world's largest economy in 2021. It's an ambitious forecast based on an astonishing 7.75% average annual growth rate. Even more astonishing is that China has been meeting the magazine's targets, at least until recently. This summer the Chinese economy hit an unexpected road bump. Industrial production fell 0.4% in August, a rare event that sent shock waves throughout the commodity markets. Our own resource weighted TSX was spluttering long before the October crash.
It's not the first time Chinese growth has slowed in recent years but until now the government has always stepped in and applied stimulus. This time it seems to be different. There are indications that Premier Li Keqiang is determined to implement deep reforms and in particular wean people away from their mushrooming debt. Flemming Nielsen, vice president at Dansk Bank, believes Beijing's regulators are engineering a "credit crunch", regardless of short-term pain. Certainly the economic weakness is widespread. Bank loans have been shrinking, electricity output is down 2.2%, and all-important steel production has fallen for the first time since 2000.
There is another trend we have to keep an eye on. China's central government is steering growth toward consumption rather than capital expansion. That suggests less demand for imported raw materials and energy. In that case, oil and other commodity prices are likely to remain relatively soft and hurt a lot of Canadian corporate earnings in the months ahead.
There is, however, good news on another front. The U.S. economy shows signs of life. According to revised figures, American GDP grew 4.6% in the second quarter, well ahead of a 3% consensus forecast. Revised third-quarter GDP growth came in at 3.9%. Even more encouraging is the fact the gathering strength is broadly based.
September's numbers were solid. Unemployment fell to 5.9%, the lowest rate since July 2008. The Institute of Supply Management (ISM) reported expansion in the manufacturing sector for the 16th consecutive month with growth in 15 of its 18 industry groups. Spurred by falling gasoline costs and rising house prices, people are more optimistic. The Consumer Confidence Index has jumped to 89.4, its highest reading since July 2007.
All this suggests a shift in economic power as we head into 2015. Nobody doubts that China is going to remain a significant force but the U.S. has momentum. A resurgent U.S. and retreating China reverses a trend that has dominated since the 2008 crash and is a huge plus for the rest of the world. With a US$17.3 trillion GDP compared to China's US$10.8 trillion, the United States controls 18% of the world's purchasing power. It's the big engine we need. Economists at JPMorgan Chase estimate a one-percentage point change in U.S. demand alters gross domestic product elsewhere by 0.8 of a point.
What does it all mean for small investors? For years our resource-based Canadian market has been riding on China's coattails. Whenever the Asian giant beat analysts' forecasts, which it consistently did, the TSX surged. That is likely to change. From now on China is going to send mixed signals and I think our commodity stocks are likely to have a rocky ride in the year ahead.
On the other hand, a U.S. recovery, especially if it brings the struggling Eurozone onside, will allow other sectors to pick up the slack.
On balance, therefore, I think Canadian stocks are going to perform unevenly throughout most of 2015 but finish higher. Given present trends we could see an 8% increase in S&P/TSX Composite earnings with oil prices the big question mark (I have used US$85 a barrel as an average, which may be too high). Applying the current 17 price multiple, that would give us a year-end 2015 Composite at around 16,350. Financials and industrials offer the best prospects. It's a subdued outlook now that we have become accustomed to 10% plus growth rates but it's in line with historic norms.
American stocks are a different story. They are supported by a massive, well-diversified economy that is becoming energy self-sufficient. International commodity prices are not a significant factor. Moreover, the U.S. market is well diversified and its consumer sector is particularly resilient. The only serious question mark at this stage is whether a lot of next year's economic and corporate earnings growth is already built into the stock market. At the time of writing, the S&P 500 was priced at 18 times this year's earnings. It's not cheap. Are there any fair values?
My feeling is that earnings multiples are a superficial assessment. There are other forces at work right now. For instance, equities remain a bargain vis-a-vis bonds and property. Institutional investors are awash with cash and aggressive U.S. stock buyback programs are draining blue chip floats. In addition, analysts have been raising their earnings forecasts now that the economy is coming to life. A recent survey by research firm Birinyi Associates showed the top Wall Street strategists expect to see the S&P 500 at 2,200 by mid-2015 with perhaps a pullback to 2,100 by year-end. I would not set much store by that sort of precision but obviously the forecasters are bullish and that's half the battle. They instill optimism.
Always keep in mind as well that so-called fair value is a moving target. As companies increase earnings, raise dividends, and improve cash flows, their intrinsic values tend to increase. As long as industries expand, the stock market climbs, even if earnings multiples remain constant.
Nevertheless, it would be a good idea to moderate our expectations going forward. Returns over the last five years were driven by a recovery in earnings and price multiples from the bottom of a financial disaster. Now that things are on a relatively even keel we should look for mid to high single digit total returns with occasional setbacks along the way.
All things considered, the U.S. market is poised for solid, although more subdued, growth. Assuming an 8.5% index earnings increase, I think we should look for approximately 2,200 on the S&P 500 in the coming year. With bonds likely to remain unattractive, I would remain fully invested in good quality stocks especially those deriving most of their earnings in North America. Stay with your long-range strategy but give some thought to a heavier weighting in U.S. equities.
Do not venture offshore. The uncertainty in Eastern Europe and the Middle East is going to continue. European economies remain fragile. Japan is floundering. We are in the later stages of a bull market, a time to remain more defensive, so if anything opt for blue chips.
Here are four U.S. stocks that I particularly like for the coming year. All were previously recommended but I want to reinforce their suitability in the current environment. All dollar amounts are in U.S. currency.
United Health Group (NYSE: UNH). This is a leading health care services company providing benefits to 45 million people across the U.S. and 4.8 million in Brazil. More than 75% of its revenues are generated from healthcare premiums and fees with the balance coming from various medical data and analysis services. At present, there is uncertainty in the health care industry because of new government reforms but on balance the laws are positive for care providers. As a matter of fact, the industry helped to draft them.
This is major blue chip corporation with a $93 billion market value. Sales this year should exceed $130 billion and profit is likely to come in at $5.70 a share, increasing to $6.25 or more in 2015. United is adding Medicaid members at the rate of one million per annum.
I first recommended this stock on March 2 of this year at $76.01. It is currently trading at just over $100, well through our $90 target and up 32% my recommendation. That's an impressive performance and I think there is a lot more upside potential. This is a story of strong earnings growth and a history of beating consensus forecasts.
Action now: United Health is a Buy with a revised target of $120.
J.B. Hunt Transport Services (NDQ: JBHT). This company provides truckload, intermodal, and contract carriage facilities to customers across a diverse set of industries in the U.S., Canada, and Mexico. It specializes in handling imports and has developed and successfully marketed a "shore to door" service. The key, though, is an intermodal segment that represents approximately 60% of revenues and 75% of operating income in a solid, growing market. Major customers include the Burlington Northern and Norfolk Southern railways.
The company is on track to book about $6.2 billion of revenues in 2014 and report earnings of $3.25 a share this year, followed by a significant jump to the $3.75 range next year. It may do even better because Hunt enjoys a rising tide. Analysts expect a surge in transportation demand as the U.S. economy picks up steam.
The stock is currently priced at $81.41, a 6.3% capital gain since our original recommendation at $76.56 in May.
Action now: J.B. Hunt remains a Buy and I am increasing the target to $92.
Norfolk Southern (NYSE: NSC). This has been a long-time favourite of mine and has performed well over the years. At present, the stock trades at $107.07, a gain of 104% from our Buy price of $52.52 in December 2009. It has traded above our $110 target and still represents excellent value.
This railroad operates 20,000 route miles serving 22 eastern states and Ontario. Medium-term trends in all of its markets remain favourable and capable of supporting increased traffic as the economy recovers. Revenues should increase to almost $12 billion this year with earnings of $6.50 a share followed by about $7.50 in 2015.
Here, as with J.B. Hunt, intermodal business is very important and now represents 50% of total carloads. The company's heavy exposure to the resurgent auto industry is also a major plus. NSC services 24 assembly plants, 14 of which belong to Ford, Chrysler, and General Motors.
The primary reason why I like the stock, though, is that railroads continue to take market share away from inefficient trucking companies. Once written off as a sunset industry, trains are the wave of the future.
Action now: Norfolk Southern is a Buy with a $130 target.
Simon Property Group (NYSE: SPG). This is one of the largest U.S. property owners with a diverse tenant and geographical mix. Its assets are primarily regional malls, outlet centres, and community/lifestyle projects. Revenues are increasing steadily and should top $6 billion next year. I am also encouraged by the fact that the majority of SPG's tenants are under long-term leases and this reduces volatility. It also allows for meaningful financial planning.
Current occupancy is an impressive 97% and lease renewals are being negotiated with as much as 17% rental increases. Perhaps most important, Simon's powerful balance sheet and $55 billion market capitalization allows the company to refinance debt at preferred rates and maintain profit margins.
Funds from operations (FFO), the best way to judge this type of company, are expected to increase to about $8.75 a share in 2014 and $10 or more next year. Analysts expect an increase in the current $5.20 dividend.
The stock, which closed Friday at $180.83, was first recommended at $159.91 in March. It should perform well in 2015, especially as management plans to provide a bonus by spinning off certain properties to shareholders.
Action now: Simon Property is a Buy with a $200 target.
