Investors pummeled by poor returns as of late may find a “hidden opportunity” in Canada’s energy sector, according to Jeff Rubin, chief economist at CIBC World Markets.

In a report released today, Rubin points out that while the pain of $100 US oil can be felt at the pumps, the high cost of crude hasn’t trickled down to the price of energy stocks.

“The TSX oil and gas index should be trading about 35% above current levels,” estimates Rubin, in his monthly Canadian Portfolio Strategy Outlook report. Instead, energy stock valuations appear to peg oil prices at 25% below the $100 US per barrel price — a price entrenchment Rubin expects to continue through the rest of the year.

“While the energy index tracked crude’s rise closely to $75 US, it has priced in little of the increase since,” explains Rubin.

One factor that contributed to the gap in the index has been the low price of natural gas, which has constrained valuations. Rubin doesn’t expect this under-valuation to continue as gas-fired power generation plants take the place of cancelled coal-fired plants. Instead, Rubin predicts double-digit natural gas prices as North America’s utility demands start to surge.

Due to these factors, Rubin is certain that energy and commodity stocks — many of which originate from Canadian issuers — are well positioned to “significantly outperform the U.S. market.”

If that wasn’t a convincing enough reason, he also asserts that these stocks will offer Canadian investors greater diversification.

He writes, “While stock market returns around the world are becoming increasingly correlated, TSX returns bucked the trend by diverging markedly from global performance.”

Since the beginning of the decade, the TSX total returns have been 7% better than that of the S&P 500 per year and Rubin and his team predict that this outperformance will continue for the rest of the year and into 2009.

“Two-thirds of the TSX’s superior total return performance of the S&P 500 over last year was due to the outperformance of various Canadian sectors over their U.S. market counterparts,” explains Rubin. “This is particularly true for energy and material stocks, which, since the beginning of the year, have played decisive roles in the better overall performance of the Canadian markets.”

For investors and advisors trying to decide where to put their money, Rubin suggests investing in domestic stock.

“In a sharp reversal from the past, a dollar invested in the Canadian market now offers greater opportunity for diversification for investors with sizeable U.S. dollar exposure than a matching amount placed in European and Asian stocks.”

Rubin is following his own advice. His model portfolio continues to be heavily overweight in these sectors. Yet, this month, he is shifting more funds into energy. That increase is funded by a 1% cut in telecoms, where he remains underweight due to slowing revenue growth and a softer global M&A environment.

Rubin is also bullish in the materials sector, which has been the TSX’s leading performer in 2008. He predicts prices for a range of non-energy commodities will be firm in 2008, as supplies remain stretched for many minerals and industrial metals.

He also believes gold’s recent retreat will prove temporary given a continuing weak U.S. dollar, inflationary jitters and further anticipated U.S. Federal Reserve rate cuts.

Based on anticipated rate-cuts, Rubin’s model portfolio remains overweight in bonds as well, expecting another 75 basis-point interest rate cut from the Bank of Canada and a 100 basis-point rate cut from the U.S. Federal Reserve Board.

Filed by Romana King, Advisor.ca, Romana.King@advisor.rogers.com

(04/02/08)