Go Canada!

Source: @DeanTheBassett

  By Guest Blogger Doug Rowat

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The S&P/TSX Composite has, for the most part, underperformed the S&P 500 for more than a decade, but I’m arguing that 2024 will be a year of outperformance.

Granted, with oil prices rangebound, the Magnificent 7 stocks soaring and our market already underperforming y-t-d, it’s a tough case to make.

But hold my Timmies.

First, oil prices don’t necessarily need to carry the load. Not as long as financials make up more than 30% of the S&P/TSX Composite.

And, specifically, this has the potential to be a good year for Canadian banks. Canadian banks have underperformed the broader Canadian market now for two consecutive years, but the banking sector hasn’t underperformed the S&P/TSX Composite three years in a row in more than a half century.

And typically, two underperforming years are followed by at least one strongly outperforming year (usually more). For example, after underperforming the S&P/TSX Composite in both 2019 and 2020, Canadian banks, on a total-return basis, rocketed more than 38% in 2021 versus a 25% total return for the S&P/TSX Composite.

One of the catalysts for Canadian bank outperformance this year may come from a simple source: yield and dividend growth. Below are the current yield and dividend metrics for the Big Six banks:

Canadian banks – key dividend metrics

Source: Bloomberg, Turner Investments

It’s an opportunity therefore for investors to lock in a better than 5% yield from Canadian banks, which is compelling given that recent annualized dividend growth has been close to 9%. Now, there have certainly been periods where the Canadian banks haven’t raised their dividends (during the financial crisis, during the global pandemic, etc.), but if you’re willing to assume that a major economic crisis won’t materialize (a likelihood, but not a certainty), it’s hard to argue that more bank dividend increases won’t ultimately drive bank share prices higher. Further, most bank share prices have lagged in their response to the more recent dividend increases. A ‘catch up’ share-price move is possible. The below Royal Bank chart, as an example, illustrates both points:

Royal Bank share price (white line) vs Royal Bank dividend per share (orange line) – 10 years

Source: Bloomberg

But specifically, we’re arguing for the S&P/TSX Composite as a whole to outperform the S&P 500, so how does the overall Canadian market stack up?

First, as Bank of America also recently pointed out, our market yield, relative to the US’s, is unusually attractive. This is a result of the high bank yields noted above, but also the high yields in other areas including the pipeline and REIT sectors. In fact, the S&P/TSX Composite’s yield advantage over the S&P 500 is more than three times its long-term average:

S&P/TSX Composite dividend yield advantage (or disadvantage) over S&P 500 – 30 years

Source: Bloomberg. White line = average yield spread.

If interest rates and bond yields move lower this year, as is expected, the much higher dividend yields of the Canadian equity market will look comparatively attractive and should attract investor interest.

Our market’s also inexpensive. On a price-to-earnings basis, the S&P/TSX Composite trades at a massive discount to the S&P 500 (those Magnificent 7 stocks don’t come cheap), and on a price-to-book basis, there’s an even more extraordinary discount. The P/B spread between the two markets is the widest that it’s been in decades:

S&P/TSX Composite P/B ratio (white line) vs S&P 500 P/B ratio (orange line) – 20 years. Relatively speaking, Canada’s extraordinarily inexpensive.

Source: Bloomberg

Are the risks to my ‘Canada outperforms in 2024’ forecast vast? Yes. The Magnificent 7’s momentum may continue, presidential election years typically result in great returns for US stocks, and with only 1-2% economic growth expected from most developed countries this year, oil prices are unlikely to co-operate.

But I’m sticking with my forecast. You can hand me back my Timmies.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.