Thanks to energy and financial stocks, the Canadian market has been on a roll, rising 21.9% in 2005, 14.5% in 2004 and 26.7% in 2003. While these two sectors — which account for 27.4% and 31.6%, respectively, of the S&P/TSX composite index — will no doubt have a role in any 2006 gains, market forecasters also see opportunities in less influential sectors, such as consumer staples, industrials, utilities, telecommunications and health care.

“In the coming year there will probably be a leadership change in the market as investors shift away from the cyclical and resource stocks to higher-quality, blue-chip growth companies.”says David Picton, president of Toronto-based Synergy Asset Management Inc. and manager of a handful of funds, including Synergy Tactical Asset Allocation Fund, offered by CI Investments Inc.

“The basic premise of 2006 is that extremely strong corporate fundamentals will meet with an imminent slowdown in economic growth as higher interest rates take hold,” Picton adds.

Overall, specific stock recommendations are leaning toward the defensive side, with many stock-pickers moving up the ladder to bigger and stronger companies that have the stamina to withstand any slowdown in the pace of economic expansion.

Although the Canadian economy has moved into the new year with a spring in its step, there are threats — inflation, rising interest rates, unstable energy prices and a cooling real estate market — that could shorten its stride. But as long as none of these negatives are severe enough to spook consumers, the economy should retain its basic good health. Growth probably will not match last year’s, but most forecasters are expecting another year of gains.

Of course, there are some naysayers. Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal, is worried that Canadian corporate profits will fall behind last year’s; the bank has a 12-month target range for the S&P/TSX composite of 9,600 to 9,900, down from the 11,272 at which the index closed in 2005.

“If the past is any guide, the outperformance of the Canadian benchmark relative to its U.S. counterpart will be followed by a long period of underperformance as investors reassess their views on the upside of energy stocks and the fair value of oil in a downturn of the business cycle,” says Gignac.

Forecasters admit that Canadians may be hindered by higher interest rates and the rising cost of filling their gas tanks and heating their homes — and retailers and household durables could feel the pinch. Many fund managers are particularly leery of stocks tied to discretionary consumer spending, although they still tend to like consumer staples. Shoppers Drug Mart Corp., for example, is a favourite in many portfolios. In industrials, railways are popular due to their role in transporting resource commodities to customers and ports. Another company favoured by more than one fund manager is SNC-Lavalin Inc., a construction and engineering firm with a geographically diversified portfolio of projects.

Ted Macklin, managing director of Guardian Capital LP and lead manager of GGOF Canadian Large-Cap Value Fund, is one of those who likes Shoppers. He is putting some of the proceeds reaped from selling energy stocks last fall into Shoppers, as well as into stalwart food-processing and distribution giant George Weston Ltd. Macklin also likes communications giant Thomson Corp. and Fairmont Hotels & Resorts Inc., the latter of which, he says, has a strong franchise and is well positioned in Western Canada. On the telecommunications side, he is underweighted but likes Rogers Communications Inc. and is optimistic about the potential of its wireless business. Cognos Inc. is a long-standing favourite, and he also likes wireless specialist Research in Motion Ltd.

Macklin is slightly overweighted in industrials, and likes Canadian Pacific Railway Ltd. — because of the boost to rail traffic that resource commodities are providing — heavy-equipment distributor Finning International Inc. and SNC-Lavalin. Finning, he says, is positioned to benefit from global expansion as well as development of the Alberta oilsands.

“We took profits in some of our oil and gas stocks in September after hurricane Katrina sent prices soaring,” Macklin says. “We are ‘long-term constructive’ on energy, but ‘short-term cautious’.”

Vincent Delisle, director of strategy at Bank of Nova Scotia in Montreal, is looking ahead to the end of the interest rate tightening cycle in the U.S. in the spring, which will be good news for stocks and will probably be anticipated by the market. In Canada, the new federal tax cut on dividends will give an extra shot of strength to dividend-paying stocks, which will stimulate a shift from cyclicals to high-dividend companies such as financials and utilities, he says.

@page_break@But he sees some risk in that the bull market in Canada, after three years of double-digit gains, is getting long in the tooth. Earnings will have to “step up to the plate,” he says, for the bull to continue to run. Delisle’s 2006 yearend target for the S&P/TSX composite index is 11,500, a gain of about 2%. He expects the Canadian market to be surpassed by the U.S. market, which will gain about 10% in this year as it catches up after lagging in 2005.

Positive on industrials

On a sector basis, Delisle predicts the Canadian market will be led by financials, telecommunications, health care and gold (his top commodity pick), followed by energy. He is positive on industrials, specifically railway stocks, and neutral on companies tied to discretionary consumer spending.

“There will be a constructive cooling off in the housing market rather than a shift from boom to bust,” Delisle says. “It should simply be a matter of taking some foam off the top.”

Due to its negative stance, NBF is limiting its overall Canadian equity allocation to 17% of assets, down from its balanced portfolio benchmark allocation of 25%. On the positive side, banks, diversified telecommunications and utilities are the most likely beneficiaries of the Canadian government’s efforts to level the playing field for dividend-paying stocks relative to income trusts. NBF is setting a US$600-an-ounce target for gold, and views the gold-mining industry as possessing significant upside potential due to its role as a safe haven during times of turbulence in global currencies.

Dan Bubis, president of Winnipeg-based Tetram Capital Partners Ltd. and manager of Assante Wealth Management Ltd. ’s United Financial Canadian Equity Pool, is an infotech fan these days and likes electronics manufacturer Celestica Inc. and Sierra Wireless Inc.

“There’s been a lot of cost-cutting in the tech industry, and any positive surprise on the sales front will have a powerful impact on profits,” Bubis says. “Many analysts are too pessimistic and are underestimating the operating leverage in some technology companies.”

Proving that what makes a market is diversity of opinion, Richard Nield, portfolio manager at AIM Funds Management Inc. and co-manager of AIM Canadian Premier Fund, is significantly underweighted in technology stocks and is concerned about potential profit disappointments at Research in Motion and Nortel Networks Corp. He, too, likes the outlook for consumer staples, particularly Shoppers and food retailer Metro Inc. He also holds a “decent position” in Brookfield Asset Management Inc., which is the new incarnation of the former Brascan Corp. and holds real estate and power-related assets.

“We’re getting into some defensive names that, even in difficult times, tend to show solid earnings,” Nield says.

In the industrials sector, he likes SNC-Lavalin and Canadian National Railway Co. Nield is staying out of stocks that may be hurt by a strengthening Canadian dollar, including autoparts manufacturer Magna International Inc. and furnituremaker Dorel Industries Inc., which have a high percentage of U.S. revenue and would lose their cost advantages in the U.S. market. Rogers Communications, which has a lot of U.S. debt, would benefit from a sinking greenback, he says.

“Overall, we are slightly defensive and expect slower growth in 2006,” Nield says. “If the dollar stays around the US85¢ level, Canadian companies will have to pay more attention to enhancing productivity.”

Pension liabilities are a growing concern, and managers are assessing the vulnerability of individual companies to pension plan liabilities when they do their research. Nield says the big steel companies, such as Algoma Steel Inc. and Stelco Inc., may have problems with pension plan funding. When analysing companies, even the blue-chips, he takes a close look at projections of future pension liabilities relative to balance sheet strength. The ability of companies to fund pensions is also affected by their profitability, and a slide into an economic recession could create problems, he says.

While inflation has not been a major threat for many years, there are signs it could be rearing its head. Even if energy costs are not factored into the core inflation rate, they are having an impact on the cost of living. And if gasoline and heating costs remain high, these expenses will ultimately affect production and transportation, and will be passed on to the consumer in the price of core goods such as food.

“Inflation is one of the major themes developing,” says Gavin Graham, vice president and director of investments at Toronto-based Guardian Group of Funds Ltd. “It’s a long-term phenomenon rather than a cyclical spike. There’s a worldwide shortage of hard assets, such as energy, metals and alternative fuels, due to underdevelopment of new supplies during the past 20 years or so.”

Other risks include a severe drop in oil prices or a sustained gain above US$70 a barrel. It’s also possible that the monetary authorities may go too far in raising interest rates, tipping North American economies into recession and setting off global repercussions. If that happens, most managers would head even higher up the quality curve to the most stable blue-chips, and increase their bond holdings if they have the leeway in their mandates. IE