Large caps to lead in 2009: TD’s Gorman

Investors can expect North American stock indices to rise in 2009, but they’ll have to put up with more volatility before the markets find a firm footing, according to an early year-end prognostication from TD Waterhouse.

“Looking ahead to 2009, the key questions on the minds of investors are when the heavy volatility will end, what the ‘floor level’ of the current bear market will be, and when will stocks begin to recover,” says Bob Gorman, chief portfolio strategist, TD Waterhouse.

He recommends that large-cap stocks form the basis of a U.S. portfolio, due to the greater stability they typically exhibit. Larger companies also tend to outperform as recessions end, and current valuations indicate they have been oversold.

On the Canadian front, Gorman says the TSX’s 49% decline from its peak likely signals a bottom has been reached, and equities should recover in 2009. As with the U.S., large caps should outperform.

Fixed income investors can expect to earn between 4% and 4.5%, with investment grade corporates beating government issues as investors go after their higher income stream. Riskier assets should also see renewed interest.

“High-yield debt performed poorly in 2008, reflecting a dramatic widening of spreads due to concerns about rising default rates and forced liquidation by fund managers,” says Gorman. “These same issues will weigh on high-yield debt in the near term. However, high-yield bonds are highly correlated with equities, and thus an equity rally in 2009 will lift high-yield bonds as well.”

He predicts that European and Japanese equities will post positive returns, but does not offer a range.

Emerging markets remain a bit of a dark spot, however, as companies in these markets will scramble to refinance about $110 billion in maturing debt. Meanwhile, growth is expected to moderate in economies that have become accustomed to double-digit advances.

Gorman owned up to the errors in last year’s forecast, though, which bore the headline, “Recession, bear market unlikely in 2008, predicts TD Waterhouse.”

“A year ago, we predicted that strong fundamentals would outweigh the impact of the sub-prime lending crisis, the economy would stay out of recession, and markets would stay out of bear territory,” says Gorman. “This prediction was overturned by the unprecedented decline in global financial markets and commodity prices.”

In that forecast, he predicted that a declining Canadian dollar would provide Canadian investors with enhanced returns on U.S. equities, which were predicted to rise for the sixth consecutive year.

“This has proven incorrect,” he writes this year. “While the loonie has fallen about 21% year-to-date and has indeed cushioned the decline in the U.S. market for Canadians, total returns have still been negative.”

Gorman points out that his prediction that the Canadian stock market would rise for a sixth year was also incorrect.

But his prediction that U.S. large-cap stocks would outperform mid- and small-cap stocks was accurate, in that the Dow Jones Industrial Average has declined less than the S&P 500, with the Russell 2000 declining the most of the three indices.

He was also correct in his forecast that European stocks would outperform Japanese equities, although this was only true in local currencies. Canadian investors saw a strengthening yen boost Japanese investment returns, while a weaker euro eroded gains.

He also foresaw the rotation out of commodities, but the credit crisis resulted in no offsetting gains in defensive sectors.

He rightly advised investors to be cautious of emerging markets, which were pummeled in 2008.

On a more positive note, Gorman was correct in predicting that bond investors would earn total returns between 4% and 4.5%.

(11/28/08)