Although markets are currently preoccupied by oil prices, they will eventually return to focusing on fundamentals according to a new report for National Bank Financial.

“Though at this writing the market continues to be disturbed by developments on the oil market, we maintain that market participants will sooner or later focus on fundamentals,” the report says. “As the Fed indicated in its latest press release, the U.S. economy is gaining traction and inflation remains moderate. Add the continuing attractiveness of equity valuations, and when oil jitters dissipate, market participants are likely to see the economic environment as positive.”

That said, NBF is continuing to underweight U.S. stocks, citing its forecast for an 85¢US Canadian dollar by the end of 2005. “Not only will loonie appreciation reduce returns to Canadian investors from foreign investment, but we think any pickup in commodity prices from the global expansion will benefit the resource-heavy Canadian stock market more than the U.S. Market,” it says.

Meanwhile, a new report from CIBC world Markets calls the U.S. Market “surreal”. It says, “We would classify 2004 as surrealistic in that the markets have not made choices. Equity index levels have been in narrow ranges with individual stock earnings shortfalls punished but sector performance has not been purely defensive. Several conflicting issues appear not reconciled in capital markets but fear is up.”

CIBC says that it expects an earnings rotation driven recovery, but it cites two risks: a renewed dollar decline, and sustained high oil prices. “ Unlike 2002 and 2003, in 2004, consensus estimates stand above ours into 2005. The improvement of operating margins has likely accrued,” it says. “The economy may do less of the heavy lifting for earnings. This increases cost sensitivity and revenue growth is a key, likely leadership delivery issue. Upcoming Q3/2004 earnings are likely to bear this out by being below consensus but we expect an earnings peak only in mid-2006, albeit a shorter cycle than post 1991. More focus on quality, delivery and revenue is called for, arguably more so than investment style or size tilts.”

Focusing on Canadian markets, NBF says that the strong commodity price environment has it upgrading its September 2005 target for the S&P/TSX index to 9500 from 9200. For the S&P 500, it reiterates a 12-month target of 1125.

“In sector rotation, our new currency target implies an earnings squeeze in some sectors, including labour-intensive industries such as furniture, textiles and clothing. However, we are still positive on Materials as we think higher commodity prices will more than offset the exchange-rate effect. Some industrial exporters might feel a sting from a higher loonie, but in transportation we feel that the worst is behind us since we expect oil prices to fall,” it says. “Finally, we are still negative on banks because of the prospect of higher interest rates, bottoming loan loss provisions and lower capital market revenues.”

NBF echoes CIBC in worrying that sustained high oil prices could torpedo its forecasts. Its forecasts and targets are based on world economic growth of 4% in 2005 (versus 4.4% in 2004) and assume oil prices averaging 35$US in 2005 (versus 39$ year-to-date in 2004). “Given the rule of thumb provided by the IMF (every 5$ of permanent oil price hike translates into a 0.3% decline in world economic growth), our economic and earnings growth forecasts could prove too optimistic if no relief on energy prices is seen until the end of the year,” it allows.