Faith in the relentless bull run of Canadian stocks is suddenly wearing thin as investors fret that expectations for the commodity-fuelled market have overshot reality.
Driven higher by rising prices for oil, gold and other resource products, the Canadian market has surged in recent months and now enjoys some of the loftiest valuations in the world, far above those in the U.S. market.
But as global stock markets fell on Tuesday, the S&P TSX composite index tumbled 195 points or 1.4 per cent, outpacing the drop in New York, where the Dow Jones industrial average fell only 0.95 per cent.
That is a significant change. Over the past few years, the TSX index has almost always bested its U.S. counterpart during good times while not falling as much during corrections.
One factor in Canadian stocks' decline on Tuesday was an about-face by investment bank Goldman Sachs, which dropped its "buy" recommendation on the TSX index. In a separate note, the firm advised clients to take profits on crude oil, copper, platinum and other commodities, saying that after recent gains the risks of holding them outweighed potential gains. Canada is a major producer of many of those commodities.
MRB Partners, a Montreal and British-based investment consulting firm, issued a report advising investors to be cautious about Canada, arguing the country's economy has "some alarming structural imbalances building. Investors should be careful not to dismiss these risks."
MRB said that Canada's record in cutting the federal deficit has been "terrible" given the huge windfall it has reaped from higher commodity prices. The firm also says the country's non-resource exporters aren't competitive.
While MRB concedes Canada is growing faster than most big countries and benefits from strong demand for commodities, it argues that share prices already reflect the good news. "Canadian equities are expensive on all accounts," it said, estimating that domestic stocks are trading at valuations 15 per cent to 25 per cent higher than global benchmarks.
One way to evaluate the Canadian market is look at its average price to earnings ratio, a measure of how expensive share prices are in relation to corporate earnings. The higher the P/E, the more expensive the market and the less desirable.
According to Bloomberg, the Toronto Stock Exchange trades for around 21 times earnings. In comparison, the S&P 500 looks downright cheap, at only 15.5 times.
Over the past five years, Canadian stocks have returned 33 per cent, compared with 13.9 per cent in the U.S. Much of the outperformance in Canada has been the result of a solid banking sector, and surging prices for oil, gold, silver and base metals, which has fed demand for stocks in companies that produce those key commodities.
Tony Boeckh, a Montreal-based money manager and newsletter writer, says he continues to like Canadian stocks because he thinks the commodity upturn will last for years. But he's been getting more inquires from outside the country asking him to recommend good investments in the domestic market. Foreign interest in a market is often a sign things might be too frothy.
"Clearly, Canada has got a great story going for it, but the big question is to what extent it's reflected in the price" of stocks, he said. "If commodities head south, the Canadian dollar is going to head south and … investors are going to take a pretty big hit."
Peter Gibson, a top-rated portfolio strategist at CIBC World Markets, says there is no doubt the TSX has "become more expensive" than many global markets, and he's started to hear comments from analysts that U.S. stock valuations are more compelling.
But he believes both Canadian and U.S. stocks can continue to march higher, because profits are expanding in both countries at a vigorous pace. Provided higher U.S. interest rates don't snuff out the bull move, he forecasts Canadians stocks can rally about another 7 per cent this year while U.S. stocks could tack on a bit more than 5 per cent.