Bill Tynkaluk thought energy and metal stocks were vulnerable before the commodity-led slaughter of the stock market in 1974, but he still recalls the jolt when it hit.

"The charts did not predict a major crash," recalls Mr. Tynkaluk, who has managed money for Leon Frazer & Associates in Toronto for more than five decades. "But all of a sudden, it happened."

The crash of 1974 is a nightmare vision of what could happen to today's Canadian stock market as a result of its domination by commodity stocks. By the end of '74, the Toronto stock market was down 29 per cent, one of its worst annual declines ever. The Toronto Stock Exchange's oil and gas index lost more than half its value, metal stocks were down about 40 per cent and gold was off 40 per cent from its peak for the year.

Over the past few years, these very same sectors have come to represent just under half of the S&P/TSX composite index. So far, it's all been good. Soaring prices for oil, metals and fertilizers have made Canada's stock market one of the world's best performers over the past five years.

Still, there's reason for investors to be nervous. For one thing, markets that are tilted massively to one or two specific sectors have fallen hard in the past. For another, there's almost no way to make money in the Toronto market these days outside of commodities. "The S&P/TSX is now entirely a slave to the commodities sector," said RBC Dominion Securities strategist Myles Zyblock.

It may come as a relief to investors that the 78-year-old Mr. Tynkaluk and his 82-year-old associate, George Frazer, do not see direct parallels between 1974 and now. Back then, an Arab oil embargo triggered by the 1973 Yom Kippur War in the Middle East helped fuel a rise in oil prices that in turn contributed to an inflation surge above 10 per cent and an economic recession.

"Commodities today are a different game than they were years ago," said Mr. Tynkaluk, who began working at Leon Frazer in 1956. "You've got demand today from China and India and the other developing counties, all looking to increase and improve their infrastructure. China wasn't heard of in 1974, and neither was India."

The Nifty Fifty

High commodity prices today are an everyday fact of life in the financial world. Bank of Canada Governor Mark Carney said last month that we are experiencing a "commodity supercycle" and indicated the central bank expects energy prices to remain at high levels. Reputable forecasters at CIBC World Markets and Goldman Sachs have predicted oil prices could rise to $200 (U.S.) a barrel in the next two to four years.

But stock market history warns against investor complacency. In fact, the year 1974 is just one example of how carnage can ensue when investors flock to a sector or class of stocks and ignore everything else. Commodities once again dragged the Canadian market down in 1981, while the collapse of the Nortel Networks-dominated tech sector debacle was a key event in the bear market that kicked off this decade. In the U.S. market, the early 1970s are remembered for an obsession with the Nifty Fifty, a group of big names like McDonald's, Polaroid, Xerox and Disney.

These companies, seen as must-own "one-decision stocks," helped drive a bull market in the early 1970s as they soared to prices that today seem absurd. Example: Polaroid's price-earnings ratio — the classic measure of how expensive a stock is — soared to 90, compared with 18.9 for the S&P 500 index. When the Nifty Fifty inevitably toppled, it took the stock market seven years to recover.

The Tech Collapse

In the recessionary year of 1981, the TSE 300 composite index, predecessor to the S&P/TSX composite, fell 13.9 per cent as the gold sector plunged 38.2 per cent, metals sank 21.9 per cent and oils dropped 15.1 per cent. TSX historical data doesn't go back far enough to show us the exact weighting that commodities had in the index back in those days, although it was considerable.

The tech sector's rise and fall is a yet another example of how the overall market pays when a key sector eclipses all others and then collapses. In August, 2000, information technology stocks accounted for 42 per cent of the index and Nortel alone made up 37 per cent. In 2001, the Toronto index fell almost 14 per cent.

Technology stocks were a classic bubble in that they surged in price because of hype and speculation, not the rising corporate revenues and profits that usually drive stocks. Commodity stocks are making real money — huge amounts of it, in fact. But they've risen so far that comparisons to technology are natural.

Research compiled by Andrew Pyle, a former big-bank economist who now works as an investment adviser at Scotia McLeod, shows that the most widely followed measure of tech stock performance, the Nasdaq, soared 1,500 per cent from October, 1990, to its early 2000 peak. Over the next three years, Nasdaq lost 75 per cent of its value.

Mr. Pyle found that oil prices surged 1,200 per cent from $10 per barrel in December, 1998, to the $140 (U.S.) level in late June. A Nasdaq-type fall would bring oil prices down to $40, but Mr. Pyle sees $70 to $80 as a more likely outcome.

"I didn't want to draw too much of a correlation with the Nasdaq," said Mr. Pyle, who is based in Peterborough, Ont. "The Nasdaq had no fundamentals, whereas you can argue there are fundamentals supporting oil. But today, things are inflated."

Dead Money

David Wolf, chief economist for the investment dealer Merrill Lynch Canada, said simple arithmetic suggests how the broader market might be affected by a downturn in commodity prices. "The energy and materials sectors together account for about 50 per cent of the index," he said. "If one were to see a 20-per-cent correction in those areas, that would translate into a 10-per-cent correction in the index if nothing else happened."

Mr. Wolf said other national stock markets have been more heavily weighted to a single stock or sector, an example being Finland, where cellphone giant Nokia in the past accounted for almost 40 per cent of the market. What concerns him about the Canadian market is less its high commodity exposure than the fact that stocks in almost every other sector are dead money.

A recent study by the investment data analysts at CPMS Computerized Portfolio Management Systems Inc. found that the energy stocks in the S&P/TSX composite index averaged a 33.4-per-cent return for the year through June 16, while the index without energy stocks averaged a 6-per-cent loss. CPMS said that while the S&P/TSX composite index was up 9.3 per cent through June 16 on a total basis (share price appreciation and dividends), the gain with energy stocks removed would have been just 1.9 per cent.

This small gain would disappear altogether if you took a non-energy commodity stock, Potash Corp. of Saskatchewan, out of the mix. Potash, the second-largest stock in the S&P/TSX composite right now, has soared in the first half of the year and has recently accounted for close to 5 per cent of the index.

It's in meteoric performers like Potash, rather than commodities in general, that Mr. Tynkaluk and Mr. Frazer see risk.

"We haven't got any Potash," Mr. Tynkaluk said. "Potash is a stock that has sold as high as, what, $240 or $245 lately? One bad announcement and that stock will be down 20 per cent so fast it's not funny."

'The World Runs On Oil'

Mr. Tynkaluk and Mr. Frazer are two of the managers of a mutual fund called IA Clarington Canadian Conservative Equity, which was founded in 1950 and happens to be one of the oldest mutual funds in the country. Over the past 20 years, the fund has delivered better annual returns on average than the S&P/TSX composite index, a significant achievement.

While you won't find Potash Corp. in the IA Clarington Canadian Conservative Equity portfolio, you will find energy stocks. In fact, oil and gas shares have recently accounted for more than one-third of the assets in the fund. "We think oil will likely come down a bit, but you can't bet against the industry because the world runs on oil," Mr. Tynkaluk said.

Oil prices have soared in the past few years in the belief that demand is growing faster than supply. Back in 1974, there was an interruption in supply that caused upward spikes in oil prices and, in turn, gasoline. Mr. Frazer recalls those days as a time when pricey resource stocks seemed ripe for a fall. "At the height of that market, we'd already sold out our position in those companies and we were buying the ones that were left behind."

Today, buying the stocks left behind by commodities means losing money. Among the sectors that are down significantly in the past 12 months are health care, consumer discretionary, consumer staples and telecom services. Financials, the top-weighted sector in the index before energy took over, has been a disaster as well. Perennially a money maker for investors, bank, insurance and fund company stocks are unattractive at a time when the global financial system has been undermined by exposure to the sinking U.S. real estate market and concerns about economic weakness.

Two sectors that have thrived in the shadow of the commodity sector are utilities and information technology. But even here, the results are spotty. The utilities sector has benefited mainly from strength in a few names like TransAlta Corp., while the story in info tech is the continuing success of Research In Motion and its ubiquitous BlackBerry personal communication device, as well as a renewal at Celestica Inc.

Playing It Safe

The two-tiered nature of the Canadian market — commodities are good, most everything else isn't — presents a challenge for mutual fund managers and, in turn, investors. Either they embrace commodities and their inherent risks, or they play it safe and endure returns that lag the S&P/TSX composite.

Lots of managers are playing it safe these days, and thus delivering returns below the very benchmark they're supposed to outperform. The indexing people at Standard & Poor's keep a running tally of how mutual fund managers are performing against the S&P/TSX composite and the most recent results were dismal.

S&P found that in the first quarter of the year, just 8.2 per cent of Canadian equity funds matched or beat the index. It's the same story over the past three years — the Canadian stock market has done well, but investors haven't fully participated through their Canadian equity funds.

Rudy Luukko, investment funds editor at the mutual fund analysis firm Morningstar Canada, said commodity prices are a wild card over which many fund managers feel they have no control. "For that reason alone, a lot of managers will tend to shy away from having a market weight in the energy sector and the mining sector."

The hardest-hit fund managers right now are the ones who follow the value school of investing, which is about finding out-of-favour stocks with rebound potential. Not much in the commodity sector qualifies here, which means value managers are the definitive case study in what happens if you don't go with the commodities flow.

Opportunity Knocks?

Simply put, these managers have been buying downtrodden stocks that keep getting stomped. An example of such a stock is publisher Torstar Corp., which has attracted noted value specialists like Prem Watsa, CEO of Fairfax Financial Holdings, and Mackenzie Financial's Cundill group. Last month, Torstar shares were trading at less than half of their $27 level of five years ago.

Why mark time with Torstar when you can buy fast-rising oil and mining shares that deliver instant results? "Torstar sells for 50 cents on the dollar right now," said Wade Burton, manager of the Mackenzie Cundill Canadian Security Fund. "If you sold [Torstar] piece by piece, you would get $25 to $30 per share."

Mr. Burton's fund has no energy stocks and no metals or fertilizers, where bargains are scarce to non-existent. About the only resource exposure it has is a few names in the forest products sector, which has not participated in the commodity boom. Net result: The fund lost 16.4 per cent in the 12 months to May 31 while the S&P/TSX composite made 7.4 per cent.

But in holding stocks that have done terribly lately, Mr. Burton sees an opportunity to profit when commodity stocks fall and investors look elsewhere for opportunity. He says the stocks in his portfolio trade at a 40-per-cent discount to their true value, which compares with a 15-per-cent discount a few years ago. "This market is throwing off opportunities that make us much more certain about what our five-year outcome will be than we were three or four years ago."

'Demand Destruction'

Murray Leith, director of investment research at Odlum Brown in Vancouver, said the experience coming out of the tech boom early this decade shows how it pays to buy stocks that aren't in sync with the market. "In the bursting of the tech bubble, we were hopeful that money would rotate into the neglected areas of the market, and that's exactly what did happen," he said. "We had a model portfolio that was up 40 per cent in 2000, and we weren't stepping out on a limb in risk."

Mr. Leith's current model portfolio, with names like Royal Bank of Canada, Manulife Financial, Tim Hortons, Alimentation Couche-Tard and Saputo, has significantly underperformed the S&P/TSX composite in the 12 months through mid-June. But he's starting to see signs that suggest the energy sector's domination of the market will decline because of falling demand for oil.

"They say they don't ring alarm bells at the top of the market," he said. "But to me, there are some pretty loud signs that there's demand destruction going on. SUV sales have fallen off a cliff, people are driving less, Air Canada's laying off 2,000 people and cutting capacity by 7 per cent, emerging markets are reducing their subsidies on energy. What's working on the stock market today carries considerable risk."

Mr. Pyle, the Scotia McLeod investment adviser, is talking to clients these days about how the appreciation of energy, mining and fertilizer stocks over the past few years may have inflated the commodity component in their portfolios. His advice: Reduce exposure to commodities.

"If five years ago I said let's put 20 per cent of your money into oil, you probably would have said: 'Are you crazy?'" Mr. Pyle said. "Yet that's where people are today, through no fault of their own. We're very strong advocates of taking money off the table."

The perspective of more than 110 combined years of successfully managing money has persuaded Mr. Tynkaluk and Mr. Frazer that 2008 is nothing like 1974, the year commodities were crushed. But while they continue to hold lots of energy stocks, they've added balance to their portfolios by including some stalwart utility stocks among their top holdings, as well as beaten-down financials.

"George and I have seen ups and downs in the markets like you wouldn't believe," Mr. Tynkaluk said. "We haven't always made the right decisions, but we're still here and we don't lose many clients because of poor performance. We lose clients because of death."