TSX stocks are nearly at fair value say CIBC World Markets Corp. economists, Avery Shenfeld and Peter Buchanan in a new report. The trick for investors will be to hunt down stocks that still offer value in such sectors as energy, financial services and consumer staples.

“The easy gains are over for stocks,” the say in Finding Value in TSX Dividends. “The TSX composite climbed 35% in the past year, first on the resolution of the Iraq war, and then on confirmation of a global economic recovery. Price-earnings ratios, the short-cut guide to valuation, look moderately expensive by historical standards. Although interest yields on fixed income assets are also low, we’re also further into the earnings cycle, a point at which better base earnings makes subsequent growth tougher sledding.”

The pair argues that a dividend discount model, one that allows for both low interest rates as well as for earnings growth beyond 2004, is key to assessing where value lies in the TSX. “Overall, even with low interest yields, our dividend discount model finds that TSX stocks are nearly at fair value. Given a backdrop of positive U.S. economic news through the first half of 2004, it’s not time to bail, but it is time to hunt down sectors that still offer value in terms of buying dividend growth at a reasonable price.”

CIBC’s earnings model projects that TSX operating earnings are poised for only a 13% gain in 2004 vs. the 21% bottom-up consensus. Beyond 2004, it expects earnings growth to settle in a bit above underlying growth in nominal GDP. “With inflation muted in this cycle, that will entail a move to trend growth of roughly 7% for TSX operating earnings by 2007.”

“Fortunately, there’s room for dividends to ramp up at a faster pace than earnings in the next few years,” it says. “Cash dividends reflect earnings expectations, resulting in a partial adjustment process towards target payout ratios. Typically,when earnings have shot upwards, it takes up to four years for corporate dividends to catch up.”

While stocks can stay above fair value in the short run, they says that the next gain for equities will likely have to await a further drop in bond yields . Still, “Within the TSX composite, some GICS sectors would appear to have much more upside than others based on current valuations and dividend potential,” they say. “Recent momentum in dividends has been paced by financials, consumer staples and energy. Announced payouts for Q1 will actually be down on a year-on-year basis in the latest quarter for industrials and materials.”

“Right now the energy, financial and utilities sectors appear cheap according to a dividend discount approach, using our earnings projections… Materials stocks are overvalued given that the resource price upswing will soon reach its typical post-war duration, and industrials are similarly overpriced as a still-firm Canadian dollar cuts into profit margins,” it says. “Even with 20%+ earnings growth, infotech growth stocks wouldn’t be growing cash and dividends fast enough to justify current valuations, given the penalty imposed by their high beta. The dividend discount results show just how vulnerable tech valuations would be to even modest disappointments in growth.”