U.S. equity market is entering a mature phase in the cycle, making corporate efficiency and recovery more important than ever, CIBC World Markets says.

“The sharp recovery of equity markets and the decline of corporate spreads over Treasuries indicate that forward-looking behavior has expanded sharply,” CIBC says in a new report. “Statistically, the earnings cycle bottomed in late 2001. We anticipate the sharp earnings recovery from the bottom to evolve into slower expansion from mid-2004 onwards with a potential earnings peak in 2006.”

CIBC is bullish on earnings, but valuation is becoming a concern. It is calling for fourth quarter earnings for the S&P to show 27% year-over-year gains compared to consensus estimates of 22%. “However, as the S&P 500 crossed the 1075 level in late 2003 it was already building in earnings recovery likely well into 3Q/2004,” it says.

“Increased new issue and merger and acquisition activity corroborate our view that the market has entered a more mature market phase With the S&P 500 currently at 1132, the breadth of the earnings recovery in terms of sectoral contributions and the market response to individual earnings becomes crucial,” it says, suggesting that there is limited room for continued upside surprises.

“Efficiency and corporate recovery are likely key hallmarks for this market cycle and U.S. consumer expansion less so,” it says. “These early trends for 2004 indicate broad overall stability for the markets in which rotation will likely be key. We would focus on rotation from a cyclical earnings/technology recovery bias in 2003 towards a recurring earnings-driven stance for 2004 and onwards.”

In cyclical stocks, it likes industrials and materials with an underweight in consumer discretionary names. Among growth stocks, it overweights health care, “looking towards restructuring in pharma, and watch for the delivery of results from restructuring accomplished in household/food products within underweighted consumer staples”.

“In market-weighted info tech, we would rotate towards the recurring earnings segments with less exposure to lower quality, which were the outperformers of 2003,” it says. “In financials, we are market weight for this stage of the cycle, favoring banking and less exposure in consumer finance. For diversification, we favor energy.”

The central risk to its view is the activity in the currency markets. “We are actively watching increased central bank commentary on this topic. A prolonged, one-sided decline in the U.S. dollar could result in diminished interest in U.S. Treasuries at a time when budget deficits require foreign financing,” it comments. “Similarly, on a macro front, such depreciation could constrict Japanese recovery and stretch the European lag, calling into question global recovery. We see dollar recovery, such as that seen in recent days, as a positive for the stability of the overall markets.”