Investment outlook 2010

By Robert J. Gorman, CFA, Chief Portfolio Strategist, TD Waterhouse

Construction workers build the frame of a house.

U.S. housing is in the process of bottoming and is expected to begin a gradual recovery in 2010.

A year ago, when looking ahead to 2009, we stated that stock market opportunities were presenting themselves based on attractive valuations and ample liquidity along with supportive monetary and fiscal policies. As of early December, Canadian, U.S. and major foreign markets had met or exceeded anticipated returns. (See chart, “North American stocks recover.”)

Concerns on the front burner

As we examine the stock markets’ prospects for 2010, a handful of concerns weigh heavily. U.S. housing remains a problem, with foreclosures at high levels as a result of high unemployment. At the same time, many U.S. homeowners’ adjustable-rate mortgages are being renewed at higher rates and higher mortgage payments they can ill afford.

Nonetheless, we maintain that housing is in the process of bottoming and will begin a gradual recovery in 2010. U.S. commercial real estate is a serious problem that will linger for several years and cause further pain for American regional banks.

In addition, consumers, especially those stateside, are understandably cautious, saving more, reducing debt and spending less. While this “right-sizing” of consumers’ balance sheets will be beneficial in the longer term, it will mean sluggish consumer spending and a tepid economic recovery in the near term.

Positive factors

Notwithstanding legitimate concerns, we see a number of important positive factors supporting stock markets in 2010:

Stock valuations are reasonable, with the S&P 500 trading at about 14.5 times 2010 estimated operating earnings, a multiple in line with the historical average.
Credit markets have clearly improved, with measures of fear in the financial system sharply lower than a year ago, corporate bond issuance surging and a steep yield curve, which is very beneficial for the U.S. banking system and generally portends an improving economy.
Monetary and fiscal policies are very accommodative, with short-term interest rates low and government spending high.
We will have moderate economic growth, enough to improve corporate profits but not enough to ignite inflation and necessitate a dramatic tightening of monetary policy.
Corporations, especially in the U.S., have recorded major gains in productivity as they have slashed labour costs. Meanwhile, inventories have been sharply reduced. Both events augur well for profitability when sales volume improves.
Liquidity, or cash on the sidelines, remains at exceptionally high levels relative to stock market capitalization, reflecting investor uncertainty. This cash represents latent buying power, some of which is likely to make its way into equity markets in the coming months.

The road ahead

Overall, we expect North American stock markets to advance for the second successive year and generate high single-digit returns in 2010. Expect a rotation of market leadership from the small caps and more volatile sectors to larger companies with more stable sales, earnings and dividend growth, which have lagged in the recovery to date.

Overseas, the European economic recovery seems on track, paced by strong exports. Stock valuations are attractive, with low P/E multiples and high dividend yields. We anticipate high single- or low double-digit returns, led by the large caps. Emerging markets will not match 2009’s gains but upper single-digit economic growth plus solid earnings growth in China, India and Brazil should result in high single-digit returns in 2010, accompanied by high volatility.

We expect modest bond returns in the range of 3% to 4%, with investment-grade corporate bonds outperforming government issues for the second successive year but by a much narrower margin than in 2009.

Overall, we expect 2010 will be the second consecutive year in which it will be more advantageous to be an owner — an equity investor — than a lender — a fixed-income investor.

Chart: “North American stocks recover” showing double-digit gains posted in 2009 by both the S&P/TSX Composite Index and the S&P 500 Index.