The Globe and Mail, Report on Business
Published July 25, 2009

Knowing the right questions to ask is an important and difficult part of any decision-making process.

For the last two weeks I've been parked on the edge of Crystal Lake, Ont., where the right questions have been: Is the water calm at the slalom course? Will the old guys, Lance Armstrong and Tommy Watson, have the legs to win? And do I really believe Malcolm Gladwell's theories in Outliers?

I've also had some time to pull back and think about the key questions that investment managers need to be asking now. Three key ones rose to the surface.

Should we be preparing for inflation?

Investors must come to grips with this question. The unprecedented amount of fiscal and monetary stimulus that's going into the economy makes higher inflation a distinct possibility.

While I don't have a definitive view on the issue (there are strong forces on both sides), I'm not waiting around to figure it out. The chance of rising inflation is high enough, and the risk to a retirement portfolio significant enough, that I want to be prepared.

In this environment, a portfolio should have exposure to assets that will inflate along with the consumer price index (CPI). Gold, real-return bonds (RRBs), real estate and stocks, where the value is based on hard assets, are all possibilities. With the exception of RRBs, nothing is a perfect hedge. Higher interest rates, which go hand-in-hand with rising inflation, will depress valuations on all types of assets. But some will hold up better than others.

Where will the next market leaders come from?

I always assume that in a new business cycle a new set of leaders will emerge at the country, industry or company level. And yet, investors tend to focus their attention on what led the market in previous years and find it hard to imagine that those stocks won't do it again. The most recent illustration of this came in 2002-04 when many investment managers were intently watching for an entry point into technology stocks, while other parts of the market were set up to perform much better. This year they're watching to see when they should buy more energy, metals and bank stocks.

These sectors have been leaders in the current rally, but three years from now we shouldn't be surprised when heath care, technology or another economic force fuels the market's rise. Health care companies still have patent expiry challenges and cost pressures, but demographics are in their favour, balance sheets are strong and stock valuations look reasonable. Technology, which has shown signs of leadership this year, will be at the centre of the productivity gains our economy so desperately needs. There are opportunities in the conventional areas of computing and communication, but we'll undoubtedly see other technologies emerge in areas such as energy and resource management.

After a significant rally, what kind of outlook is being factored into securities prices?

The question that often separates professional from amateur investors is one of valuation. Having a view on the economy or a company's earnings prospects is only part of the process. It's necessary to take the next step to determine how much of that view is already factored in to the price.

As I've pointed out previously, the current rally has largely been driven by a change of valuation, as opposed to a revised profit outlook. The market started its move at a time (early March) when there were questions about the survival of the banking system and the capital markets in general. That gloomy prospect took all stock and corporate bond valuations down. Companies didn't have to be in the financial services sector to see their price-to-earning multiples fall to ridiculously cheap levels.

So where are we today? My reading of the consensus is that managers still have modest expectations for the economy. We are facing an economic double whammy, with both consumers and governments in desperate need of deleveraging. The math appears to be irrefutable – the next business cycle will be sluggish and heavily taxed.

As for valuing that outlook, I prefer to do it on a stock-by-stock basis. I rarely find metrics on the overall market to be useful because the indexes are made up of companies at peak earnings, with no earnings, with rising and falling earnings, and companies not valued on earnings. The late 1990s provided an extreme example of this point. Tech and Internet stocks, along with a select group of global leaders like Coke, Home Depot and General Electric, pushed the market multiple into the range of 30-times earnings, an unsustainable level. Meanwhile, there were a slew of non-technology stocks trading at rock bottom valuations.

Whether it's a slew or not, there are still companies to be found where earnings estimates are achievable and the stock is trading at a reasonable multiple. In these situations, expectations can easily be met and if they're not, the consequences are less severe.

These are the questions that I'm going to focus my attention on in the weeks to come, but not for a couple more days. I've still got more pressing issues to deal with – do I need sunscreen on the dock, or a blanket?