By David Rosenberg and Marius Jongstra

Global interest rates are on the rise, the economic outlook is clouded (at best) and commodity prices have been hit since the start of the year. While it is hard to dispute that a leveraged, small, open economy reliant on commodity exports such as Canada will not be immune to these forces, our Strategizer model has seen a positive divergence of late between the S&P/TSX composite and S&P 500 outlooks.

Indeed, we have highlighted this before, but it is worth reiterating that much of this has to do with a better margin for safety built into current valuations. While the S&P 500 has gained 17 per cent year to date on the back of investor optimism that a recession will be avoided, the S&P/TSX composite has been rangebound — trading between about 19,500 and 20,500 or so, and only notching a five per cent advance on the year.

Beyond attractive valuations, we believe that fundamentals more appropriate of the economic reality, a positive technical divergence, and constructive outlooks on the sectors representing more than half the TSX are all reasons to favour Canadian equities compared to their U.S. peers.

Valuations

Valuations have ballooned back to elevated levels in the United States, while remaining in check north of the border. For example, the current forward P/E multiple sits at 19x for the S&P 500 and is just 13x for the TSX. The gap, at six multiple points, is sitting at historically depressed levels (based on data back to 2006 — the time horizon Strategizer looks back on) and marks an extreme two-standard-deviation event.

Even relative to interest rates, the equity risk premium at 390 basis points in Canada presents a much more attractive risk/reward profile than the lowly 100-basis-point premium in the U.S. These are just two examples, but even looking at Strategizer’s valuation composite — covering a range of different metrics — the story is no different. At a 46th percentile reading on the TSX, prices are more attractive and better reflect downside risks than the 90th percentile reading for the S&P 500.

Fundamentals

Indeed, the analyst community has taken note. TSX earnings per share (EPS) estimates for 2023 and 2024 have been cut by 11 per cent and five per cent, respectively, since the beginning of the year. That stands in contrast to four per cent and one per cent cuts, respectively, for the S&P 500.

Looking back over this most recent bear market period, the quarterly evolution in EPS projections (on a trailing 12-month basis) incorporates a 15 per cent peak-to-trough decline in profits. This stands at just six per cent for U.S. estimates. Assuming a rough estimate of a historical 30 per cent decline in earnings in recessions, this translates to a 50 per cent chance of recession priced in for Canadian stocks, while roughly 20 per cent in the U.S. Once again, further evidence of more bad news being “in the price.”

Moreover, despite concerns of a global slowdown, if the bulls south of the border are correct that a recession will be avoided, the reality is that, based on simple correlations, TSX earnings have the highest relation to the performance of U.S. gross domestic product. Should a slowdown not take place, and a soft landing is the actual outcome, then a catch-up trade should occur in Canadian equities, with much more room for multiple expansion given the depressed starting point on this front.

Technicals

Beyond fundamentals and valuations, there is a positive technical backdrop as well, something highlighted by Katie Stockton, founder and managing partner of Fairlead Strategies LLC, in our Aug. 24th edition of Webcast with Dave. She notes that while overhead resistance is quite strong, there is a signal being flashed that the period of poor relative performance compared to the U.S. may be coming to an end.

For the first time since May 2020, the DeMark Indicator — a tool used to identify a turnaround in relative strength — flashed that a countertrend move may be near. While not an exact timing tool, it is another in the list of signals in favour of adding exposure to Canada.

Sector composition

This is a theme we have explored before, but an argument can be made that the reason for the TSX’s underperformance this year simply comes down to sector composition. The top four sector weightings in the TSX at the beginning of the year were financials (30.8 per cent), energy (18.1 per cent), industrials (13.3 per cent) and materials (12 per cent). For comparison’s sake, the top four areas of the S&P 500 were technology (25.7 per cent), health care (15.8 per cent), financials (11.7 per cent) and consumer discretionary (9.8 per cent).

The contrast is clear, Canada has an obvious cyclical/value tilt while the U.S. is much more growth oriented, with the latter factor being an outperformer in 2023 on the back of a boom in tech/AI-related stocks. If we were to reweight the TSX to the same composition of the S&P 500, then the five per cent year-to-date performance would jump to 16 per cent, essentially in line with the 17 per cent gain in the S&P 500.

Adding to the sector differences is that the top four highly rated sectors in Strategizer — health care, financials, real estate and energy — represent 52 per cent of the market. For the U.S., it is just 33 per cent (financials, communication services, industrials and energy). Insofar as Strategizer’s outlook is correct, this bodes well for Canadian equities on a cap-weighted basis.

Alternatively, investors wanting to eliminate potential sector impacts can look to equal-weighted exposure instead.

Income opportunities

Beyond the potential for price appreciation, there are reasons for income investors to look to Canada, with a dividend yield, at 3.3 per cent, almost 200 basis points higher than that of the S&P 500 (1.6 per cent). This is a near record-high yield gap, thanks in large part to the financials (4.2 per cent) and energy (5.2 per cent) sectors offering generous payouts to shareholders while comprising nearly half the index. We can also add communication services (5.7 per cent), real estate (5.2 per cent) and utilities (4.7 per cent) with yields of greater than four per cent.

Add on the return of capital through buybacks and we are talking about an all-in yield (dividend plus buybacks) of nearly five per cent for the TSX and just over three per cent for the S&P 500. This is even more appealing when benchmarked against a lower Government of Canada 10-year yield of 3.7 per cent compared to 4.3 per cent on the U.S. 10-year Treasury — furthering the relative valuation argument.

Conclusion

All in, after a blistering rally in U.S. stocks since the beginning of the year, we feel (and Strategizer agrees) that prices have gone too far, too fast beyond what the fundamental outlook should dictate. The TSX, on the other hand, has had the other problem: overlooked by investors given its high value/cyclical exposures and the troubles the indebted Canadian economy faces from rising rates, slowing growth and a slump in commodity prices.

That said, we believe there are a number of reasons for this gap to narrow, and to take profits from the expensive U.S. market and shift north of the border.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Marius Jongstra is vice-president of market strategy there. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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