The prices of domestic materials stocks suggest the Canadian dollar is overvalued. Global commodity prices imply the loonie is undervalued. For investors, this means it's time to buy materials stocks. Let me explain.
Canadian investors are aware of the domestic currency's sensitivity to global commodity markets. When a Canadian company exports raw materials to the United States, for instance, the recipient sells U.S. dollars and buys Canadian dollars in currency markets (or their bank does) to make payment. In this sense, demand for Canadian resources translates directly into demand, and higher prices, for the loonie.
We've already used up a lot of ink and pixels exploring the important divergence between Canadian materials stocks and the value of the loonie. The S&P/TSX Materials Index has fallen almost 50 per cent over the past two years while the loonie has largely remained stable.
Historically, the value of the domestic currency (in U.S. dollars) has moved almost exactly in line with the materials index. The recent divergence suggests that either materials stocks are drastically undervalued, or the loonie is set to fall.
This all sounds perfectly straightforward – that is, until we look at the price of underlying commodities. Where resource stock prices suggest the Canadian dollar is overvalued, commodity prices imply the opposite.
The Citi Terms of Trade Index (Canada), a weighted average of commodity prices for exports by Canadian companies, highlights the apparent dilemma. The Terms of Trade Index has moved higher by 10 per cent since the end of May. The loonie, which usually tracks resource prices, has done exactly nothing during the same period – it's flat relative to the U.S. dollar.
The Terms of Trade Index says the loonie is undervalued and the S&P/TSX Materials Index says it's overvalued. Which one should investors believe?
The accompanying chart provides the answer – domestic materials stocks are trading well below the values implied by the commodities they produce (S&P/GSCI Commodity Index).
In other words, the loonie is not expensive, materials stocks are cheap, at least relative to global commodity prices.
Investors should always remember that divergences can correct in two ways. In the case of our chart, the resumption of previous patterns would see either materials stocks rise or commodity prices fall. (A hedge fund manager, confronted with this chart, would be tempted to short commodity prices and go long materials stocks – taking care of both options at once.)
On balance, the fact that resource stock prices are weak at the same time commodity prices are rising suggests this is an opportune time for investors to go bargain hunting in the materials sector.