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We the North

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  By Guest Blogger Doug Rowat

Trudeau (the original, not the sad-sack current) once said that living next to the US was like sleeping with an elephant: “No matter how friendly and even-tempered is the beast, if I can call it that, one is affected by every twitch and grunt.”

Similarly, our equity market does just fine if the elephant is happy and sleeps quietly but, of course, gets crushed if the elephant is miserable and restless. It’s also hard to win a fight with an elephant. Our main equity market has a collective market cap of only C$2.5 trillion versus the S&P 500 at US$24.2 trillion, so our odds of outperforming longer term are low. Indeed, over the past 30 years, the S&P 500 has generated a 10.2% annualized total return versus only a 7.3% total return for the S&P/TSX Composite. Over 30 years, this amounts to a cumulative outperformance of more than 1,000%.

However, every so often, an opportunity presents itself where the likelihood of our market outperforming increases. We believe we’re at such an inflection point, which is why we maintain a modest overweight to the Canadian equity market versus the US.

One of the tools that we employ with respect to our active portfolio management is relative strength analysis. Relative strength is a straightforward concept: it’s one market level divided by another. And by plotting this ratio out over time we can visually see trends developing with regards to outperformance and underperformance.

No market underperforms forever, so one thing we look for are potential relative strength ‘bottoms’. The S&P/TSX Composite has underperformed the S&P 500 now for the better part of eight years and a bottom is forming. In other words, it may have gotten as bad as it’s going to get for the Canadian market. It’s worth noting also that the last time the Canadian market underperformed for this long—during the 1990s—the WTI oil price averaged only US$20/bbl, at times dipping below US$11/bbl.

S&P/TSX Composite vs S&P 500 – A relative strength ‘bottom’ for TSX

Source: Bloomberg, 30-year monthly chart

In addition to bottoms, we also look for relative strength breakouts. This occurs when a well-established downtrend is broken to the upside. Such breaks often signal a trend reversal. Why? Because a broken trendline often indicates that market sentiment has shifted or that core fundamentals have changed. Ideally, we’d like a cleaner break of the downtrend, but nevertheless, the lengthy relative strength downtrend for the Canadian equity market has been broken to the upside—another positive signal for the Canadian market:

S&P/TSX Composite versus S&P 500 – A relative strength breakout for the TSX

Source: Bloomberg, 30-year monthly chart

In addition to relative strength analysis, we also consider valuations. And on most metrics the Canadian market is inexpensive relative to the US. As an example, the below chart compares the price-to-book (P/B) ratio between the two markets. Canada’s P/B discount to the US is currently DOUBLE its historical average.

Canada’s price-to-book discount to the US continues to widen – now double its 10-year average

Source: Bloomberg. White line = S&P/TSX Composite P/B, orange line = S&P 500, yellow line = differential, white line (lower chart) = average differential

Finally, we don’t only provide our clients with exposure to the S&P/TSX Composite, we also place an emphasis on other areas including, for example, a substantial weight to pure Canadian REITs. Canadian REITs have handily outperformed the S&P 500 over the long term:

Bloomberg Canadian REIT Index (white line) versus S&P 500 (orange) – 20 years

Source: Bloomberg

So, a combination of all of the above gives us conviction that our Canadian equity holdings are likely to outperform the US equity market over at least the next 12–18 months, hence our overweight position.

However, this is only a forecast and part of the art of portfolio management is to never make absolute wagers—exiting the US equity market entirely, for example. Such strategies are reckless. While we favour Canada, we still have a meaningful weight to the US because our forecast could easily be wrong. Further, as the earlier performance numbers suggest, it usually doesn’t pay to bet against the US market for long.

If you’re sleeping next to an elephant, you always have to keep one eye open.

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


Source: https://www.greaterfool.ca/2019/03/09/we-the-north/


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