Portfolio Strategy

Another great rotation: four reasons to cut back on Canadian stocks

The Globe and Mail

(Andrew Johnson/Getty Images/iStockphoto)

If this were hockey, we’d die of shame.

Global stock markets are kicking Canada’s butt up and down Bay Street, Wall Street or wherever. Heard of the great rotation of money out of bonds and into stocks? It’s just as important to look at reducing your Canadian exposure and adding U.S. and international markets.

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The Great Canadian Rotation is a term coined in a recent article written by the Vancouver hedge fund firm Sherpa Asset Management for Canadian Hedge Watch magazine. The firm argues that while the stock market will be the primary engine of financial returns in the next decade, “we caution investors that they could simply miss it if they do not rebalance their portfolios away from their massive weightings in Canadian equities.”

Almost 75 per cent of the S&P/TSX composite index is accounted for by financial, energy and materials stocks. Two of the most dynamic sectors so far this year are health care and technology, both of which combine to account for 3.8 per cent of the index. “If you’re any investor in the world outside Canada, you’re never going to construct a portfolio that looks like the Canadian market,” said David Guarasci, Sherpa’s chief investment officer.

Let’s give the Canadian market its due. In the world that preceded the global financial crisis, its heavy weighting in resource stocks gave it a decided advantage over most other markets. Over the past 10 years, the S&P/TSX averaged 9.2 per cent a year, the S&P 500 index averaged 2.3 per cent in Canadian dollars and the MSCI Europe Australasia Far East (EAFE) index made 3.8 per cent, again in Canadian dollars.

“The ironic thing is that having such a concentrated market in Canada has worked,” said Robert Guarasci, managing director of Sherpa’s U.S. division. “In a way, it was a mistake, but it worked.”

Now, it’s not working. The Canadian market has underperformed the U.S. market in the past couple of years and lately global stocks have pulled ahead. Sherpa offers four factors that helped launch Canada back in 1998, but can no longer be relied upon:

Oil: Prices have risen 662 per cent, with energy stocks moving up 390 per cent.

Bank outperformance: In large part because of the way they weathered the financial cri sis, Canadian banks made 182 per cent while their U.S. counterparts lost almost half their value.

Gold prices: The price of gold rose 481 per cent; gold mining companies lagged massively, but still made 78 per cent.

The dollar’s rise: The loonie’s 55-per-cent gain suppressed returns from both U.S. and international investments.

“It is hard to foresee a scenario where the asset gains caused by these four drivers could continue at a similar pace,” Sherpa says in its article. Oil prices seem to have plateaued for the moment and are constrained to some extent by rising U.S. production. The long uptrend in gold prices has, at least for now, stalled completely and the loonie seems to have stabilized at a level around par. As for the banks, Sherpa thinks they’ll be challenged by slower growth in household borrowing, notably for mortgages.

Canada represents about 4.5 per cent of the global stock market, if you judge by its weighting in the widely followed MSCI World Index. Back in the 1990s, before the S&P/TSX composite index took off, it wasn’t uncommon to hear money managers talk about keeping their Canadian exposure to similar levels. But there’s no reason to limit your domestic exposure so drastically today.

Assuming a portfolio with 40 per cent in bonds and 60 per cent in stocks, Sherpa suggests having 20 percentage points in Canada, 30 points in U.S.-based mega-companies that do much of their business globally, and another 10 points in emerging markets.

That’s a long way from what people actually own these days, Sherpa’s research shows. Looking at a blended average of the current holdings of mutual funds and exchange-traded funds sold in Canada, the firm found data suggesting Canadian investors have 60 per cent of their portfolios in Canadian stocks and just 10 per cent in U.S. stocks, roughly one-third of where Sherpa believes it should be.

You’ve already missed out on some big returns if you’re a Canada-first type of investor. In the past three years, the S&P 500 made 8.8 per cent annually in Canadian dollars while the S&P/TSX composite averaged 4.8 per cent. Last year, the S&P 500 made 12.8 per cent and the EAFE index made 14.6 per cent (both in Canadian dollars), while the TSX rose 7.2 per cent.

At least one prominent money manager thinks global stocks have lost some of their attractiveness as a result of their recent gains. “The global equity market has rebounded so strongly since March of 2009, after its sharp drop in the wake of the financial crisis, that valuations are no longer compelling,” Paul Musson, lead manager of the Ivy Foreign Equity Fund, told Morningstar.ca.

Moreover, there are those who believe Canada’s underperformance will last only as long as the global economy remains sluggish. A recent note from CIBC World Markets said Canada could reassert itself as soon as next year if growth prospects globally are realized.

Robert Guarasci concedes that the best time to have made the Great Canadian Rotation would have been two years ago. But he believes that the trends working against Canada will play out over a longer term. He also thinks the rally in the U.S. market isn’t finished. “The U.S. is coming off a 14-year period of major underperformance,” he said. “You haven’t missed it.”

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For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).