While we do expect profit growth to re-accelerate as the global economy recovers, the one worry is that profit margins are at record levels and may have very little room to rise further.  What this would mean is that we would not continue to see profit growth exceeding sales growth for most companies.  The chart below shows profit margins in the U.S.  More productive manufacturing, lower financing costs and stronger international operations will continue to support a longer-term increase in profit margins but we may have already squeezed out all of those benefits for the current cycle.Profit Growth vs Peak Margins

In Canada though, we expect that profit growth could accelerate back to double-digit rates.  Looking at the Canadian market in pieces, 40% of the index is in the resource sectors and we expect that stronger global growth and a slightly weaker Canadian dollar will at least support current commodity prices.  Moreover, the major resource players, particularly the miners, have a renewed focus on profitability which could lead to above-average profit growth and higher valuations.  The energy sector also looks like it is in the process of recovering as the spread between Canadian oil prices and world prices narrows and U.S. investors are starting to ‘look north’ again to get energy exposure.  The most notable of these was the recent declaration from Warren Buffett’s Berkshire Hathaway took its position in Canadian oil sands giant Suncor Inc. to over 18 million shares recently, representing an investment of over US$500 million.  This is not unlike his early investment in the rail sector a few years ago.  Since then, funds have flowed into that sector from other foreign investors and valuations have moved to all-time highs.  We think the Canadian energy sector is ready to ‘come out of the penalty box’ in terms of its valuations versus comparable global companies.

Another 35% of the Canadian stock index is in financials, and we see bank earnings turning higher on increased loan growth, continued strength in wealth management and growing dividends.  Canadian banks were the choice target for the short Canada crowd earlier this year on the view that our housing market was on the precipice of collapse, much like the U.S. housing market in 2007.  But after unanimously beating earnings expectations in Q3 and with the August housing numbers pouring more cold water on the hard landing thesis, bank stocks have rallied to all-time highs.  Moreover, we are starting to see some U.S. short sellers ‘capitulate’ on their ‘short Canada’ trade as short position in Canadian banks have started to come back down.

While some sentiment measures, along with seasonality, suggest a higher risk in the short-term of a correction in stock prices, we have only reduced our exposure in stocks to ‘neutral’ given that the underlying longer-term trends for stocks remains extremely good and getting the timing right on ‘corrections’ is always difficult.  One point supporting stronger stock prices is the fact that investors are largely ‘out of stocks’ right now.  While the exodus by retail investors from stocks in 2008-09 is well-known and documented, the chart below shows that the larger, ‘institutional’ investors have also moved to the sidelines.Big Investors still on the Sidelines

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