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DAN RICHARDS AND MARC ST-PIERRE

Saturday, November 08, 2003

It's never different!

In these pages last fall, we made the case that the stock market was poised for recovery and that investors who could stomach some short-term ups and downs would be rewarded for their patience. Our commentary was accompanied by a contrasting view, which argued that stocks were still overvalued.

No one could have foreseen the roller-coaster ride that followed. Significant gains in the last three months of 2002 were followed by retrenchment in the first quarter of 2003, and then strong performance in the past six months. For the 12 months ended Oct. 31, the S&P/TSX composite index gained 26.8 per cent. The broad Standard & Poor's 500-stock index, a broad measure of the U.S. stock market, was up 20.8 per cent -- or 2.2 per cent when expressed in Canadian dollars, reflecting the soaring loonie.

So, where do we go now?

Many observers remain cautious about equities. They note that valuations in some sectors, particularly technology, are reminiscent of the late 90's mania. The quagmire in Iraq is contributing to record U.S. budget deficits. There is concern that many major corporations must top up significantly underfunded pension plans. There is concern too about the ability of North American companies to meet new, low-cost competition from China and India.

A long-standing axiom holds that investing's four most dangerous words are "It's different this time."

The most apparent danger is that this declaration can encourage money-losing speculation. For example, in the late '90s those who questioned the wisdom of pouring money into stocks with unprecedented valuations and concepts with little promise of profitability were repeatedly told "it's different this time."

The less obvious danger is the cost of opportunities that are missed by overlooking the lessons of history. Many of the issues that worry market skeptics are real. Yet if you look back, every point in time had both good news to fuel optimism and bad news to cause concern. All that varied was the view investors chose. When stocks are peaking -- as in 2000 -- investors focus on good news and ignore the bad. When they are bottoming -- as in 2002 -- investors are oblivious to positives and consumed by negatives.

We believe some commentators are now painting an unduly negative picture. We are, on balance, positive about the period ahead -- for three fundamental reasons.

First, corporate profitability. Profits ultimately underpin the direction in which the stock market moves. Fuelled in part by low interest rates and easy money policies at the central banks, corporate profits are recovering all over the world: From North America to Europe to Japan. Importantly, U.S. companies are starting to increase capital spending, restoring the capacity and inventory they worked down over the past few years.

Forecasts suggest third-quarter profits for the U.S. companies in the Standard & Poor's 500 index will be up 15 per cent from last year, and fourth-quarter profits will be up 21 per cent. While these gains have already been largely factored into stock prices, a growing number of companies are beating their forecasts and show earnings momentum going forward. Skeptics may say rising earnings won't offset today's negatives because this time it's different. We say it's never different; profitability always matters.

Second, prospects for productivity growth. Companies are now reaping the payoffs from record investments in technology that were made in 1998 and 1999, driven largely by concerns about Y2K. Today's hyper-competitive marketplace and relentless focus on driving down costs are pushing productivity even more, leading to the much publicized "jobless recovery" in the United States.

A strong case can be made that innovation and rising productivity will continue to fuel economic growth. Some feel this time it's different, that rising productivity is killing too many jobs. We suggest it's never different; productivity growth is a positive for stock prices.

Third, inflation and interest rates. Interest rates reflect the outlook for inflation. We believe both will remain low.

Low interest rates are extremely positive for stocks. They encourage economic demand among both consumers and companies by making borrowing more affordable. Plus, they boost valuations for the profits that result from increased sales as demand grows.

The price paid for a company's stock reflects that organization's earnings both today and into the future. Future earnings will be worth more if inflation is low than if it is high. Wouldn't you pay more for something that's likely to be worth $100 in five or 10 years than something that's likely to be worth $75? So would other investors.

That's why, historically, low inflation and low interest rates have increased the multiple the market pays for a dollar of future earnings. Skeptical commentators miss a key point when they say today's market is overvalued because the price/earnings multiple is now above average. This multiple is not overvalued if you look at periods with comparable inflation and interest rates. Is it different this time? We say it's never different; low inflation and low interest rates always matter.

All this does not mean a return to the late '90's when investors could buy stocks indiscriminately and reap double-digit returns. What it does mean is that stocks will offer attractive returns relative to bonds and cash for those who follow a disciplined and broadly diversified investment approach, who can accept volatility and who avoid getting swept up in the market's periodic excesses. That's what happened in the past, and it's not different this time.

Dan Richards is chief executive officer and Marc St-Pierre is chief investment officer of Cartier Partners Financial Group.

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