So how do stock valuations look at this now? US stocks are currently trading at a 24% discount to their historic valuations using current interest rates and consensus economic forecasts.  More bearish investors would be quick to point out that interest rates are not likely to stay at these extremely low levels indefinitely (particularly if the recovery continues) and that current earnings estimates are too optimistic.  But the reality is that US stocks are cheap on historical valuation measures, most likely due to the exodus of so many investors from the market following the financial market crisis in 2008 and generally distrust of the mechanics of the stock market. In Canada the market is still trading well below its fair value despite the rally over the past eighteen months, as shown in the chart below which shows the UBS Model of Fair Value for the Canadian stock market (gray area shows the model’s fair value for the stock market and the black line shows the actual index value).  For most of the past 24 years the index has traded within that fair value band, rising well above it in the 1999-2000 period (during the technology bubble when an inflated “Nortel” represented almost 35% of the total index at one point).  However, following the financial market collapse in 2008, when the S&P/TSX stock index fell 55% from peak to bottom, the market has yet to recover back into the ‘fair value range.’  More importantly, if the economic recovery is indeed in its early stages, then the ‘fair value range’ will be rising over the next few years, thus adding even more credence to a bullish story on stocks.

Looking within the Canadian stock market we still feel that the better opportunities lie within the commodity stocks, which have still not fully recovered from the 2008 downturn and which, in our view, are still not reflecting the underlying strength and sustainability in commodity demand and prices.  Energy stocks have lagged the overall market by a large amount so far in 2010 and are discounting lower oil prices than what has prevailed in the markets this year. Natural gas stocks also remain under pressure due to ample supplies, particularly from unconventional sources.  However, we expect the natural gas market to tighten as industrial and seasonal demand pick up over the next few months.  The oil sands stocks have been pushed lower by environmental concerns which have lead to an exodus by foreign investors.  All of this has combined to make energy stocks look exceptionally undervalued.  As this sector accounts for over 25% of the overall index, a recovery in this sector would also help to push the index higher as well.

Gold stocks have acted well in 2010 and lead the market due to the gains in gold prices but other commodity sectors have been slower to recover.  Recent corporate activity such as BHP’s US$130 bid for Potash Corp should spread to other sectors since stock prices are still at a level where it makes more sense for companies to acquire one another rather than try to develop projects in the ground.  Given that companies are sitting on record cash balances and generating strong cash returns adds further support to the idea that we should see a further increase in corporate activity in the commodity sector. Also, commodity prices themselves, as shown in the chart below, appear to have recently broken to the upside.  Strong overseas economic numbers and renewed weakness in the US dollar are combining to drive funds back into the resource sector which, in turn, should work its way into higher stock prices in that sector.

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