Historical trends suggest the TSX is likely to outperform the S&P 500 over the next several years
Signage for the Toronto Stock Exchange (TSX) is seen in the financial district of Toronto. Photo by Cole Burston/Bloomberg Canadian stocks have had a decent run since the global financial crisis of 2008. From December 31, 2008, through the end of last year, the S&P/TSX composite index returned an annualized gain of 10.1 per cent.
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However, this pales in comparison to the performance of the S&P 500 index, which rose at an annualized rate of 16.1 per cent. Had you invested $1 million in the TSX at the end of 2008, your investment would have been worth $3,477,264 at the end of 2021. By comparison, the same investment in the S&P 500 index would have a value of $6,873,269, which is a stunning $3,396,005 more than the Canadian investment.
The composition of the Canadian stock market is dramatically different than that of its southern neighbour. As the table below illustrates, Canadian stocks are far more concentrated in financial, energy, and materials companies, while the U.S. market is more concentrated in the technology, health care, and consumer discretionary sectors.
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In 1980, the song “Lookin’ for Love,” by country singer Johnny Lee was released on the Urban Cowboy soundtrack. The tune’s iconic lyric, “Lookin’ for love in all the wrong places,” serves as a fitting description of the underperformance of the TSX versus the S&P 500. When financial, energy, and materials stocks outperform their counterparts in the information technology, health care and consumer discretionary sectors, it is highly likely that the TSX will outperform the S&P 500, and vice-versa.
Over the two years ended December 31, 2021, the information technology sector was the star performer both in Canada and the United States. Due to the far greater weighting of tech companies in the S&P 500, their stellar performance had a far greater impact on the returns of the S&P 500 than the TSX. Conversely, the underperformance of financial, energy, and materials stocks served as a drag on the performance of Canadian relative to U.S. stocks.
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The following table clearly indicates that growth of global gross domestic product is a significant determinant of relative performance of Canadian and U.S. stocks. Stronger global GDP growth has generally coincided with TSX outperformance, while weaker global GDP growth often led to underperformance. In years when global growth was below 3.5 per cent, Canadian stocks tended to fare relatively poorly; when growth was above 3.5 per cent, the TSX outperformed the S&P 500. Importantly, when growth exceeded four per cent, the odds overwhelmingly favoured Canadian over U.S. stocks.
The other key determinant in the contest between the TSX and the S&P 500 is oil, which is unsurprising given that energy companies account for about 13.1 per cent of the TSX compared with about three per cent of the S&P 500. As shown in the table below, the TSX outperformed in more than two-thirds of years during which oil rose by more than 10 per cent and did so 80 per cent of the time when oil gained more than 30 per cent. Given that oil prices had been climbing rapidly even before the Russian invasion of Ukraine, it is likely that they will remain elevated for the foreseeable future.
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The underperformance of the TSX versus the S&P 500 over the past several years has been extreme from a historical perspective. As indicated by the following chart, Canadian stocks have suffered one of their worst 10-year periods of underperformance since 2000.
Reversion to trend has been one of the most defining characteristics of markets since time immemorial. Any asset class that has dramatically outperformed for many years is likely to underperform for the next several years, and vice-versa. This suggests that the TSX is likely to outperform the S&P 500 over the next several years. Whereas historical patterns may fail to recur, it is dangerous to ignore the past, and the investment graveyard is littered with the bones of new paradigms. To quote investment pioneer Sir John Templeton, “The four most expensive word in the English language are ‘This time it’s different.’”
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More On This Topic Five strategies to help you cope with a growling bear market Value stocks shield investors from worst of 2022 market storm David Rosenberg: Don’t see a recession bear market? Here, try these glasses on Ted Rechtshaffen: Extreme pessimism and higher yields suggest it’s safe to come out and invest The notion that U.S. equities are overextended versus their Canadian peers is also supported by the relative valuations of the TSX and the S&P 500. The following graph illustrates that Canadian equities are currently trading at one of their largest discounts to their U.S. counterparts since 1994. Although relative valuations are not useful for predicting relative performance over the short term, they have historically been useful in doing so over the medium to long term. The last time the TSX Composite Index traded at a significant discount to the S&P 500 for an extended period was during the tech bubble of the late 1990s, after which Canadian stocks outperformed by 28.9 per cent over the next five years and by 83.7 per cent over the following 10 years.
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Article content Mark Twain is quoted as stating that “History doesn’t repeat itself, but it often rhymes.” From this perspective, buoyant oil prices, attractive relative valuation, and extreme underperformance over the past several years all serve as strong harbingers of Canadian stock market outperformance.
— Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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