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A woman holds U.S. and Canadian flags in Ottawa.

CHRISTINNE MUSCHI/REUTERS

The Canadian equity market is now more expensive than the S&P 500 in both trailing and forward earnings. With this week's chart, we attempt to sort out what that means for the relative future performance of domestic and U.S. stocks.

In terms of trailing P/E, the TSX is trading at 19.8 times profits versus the S&P 500's 17.2 times. Forward P/Es are much tighter with the TSX at 16.0 and the U.S. benchmark only 0.15 lower.

Trailing and forward price-earnings ratios can be misleading market signs for different reasons, so I used both in the chart. Trailing P/E has the advantage of using actual reported profits rather than estimates. But, it is less useful when business conditions change and next year's profits don't look like last year's.

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Forward P/Es attempt to incorporate new market environments, but as Yogi Berra accurately pointed out, "predictions are hard, especially about the future."

Perhaps surprisingly, forward P/E has been the better predictor of U.S. versus Canadian market performance over the past 15 years, according to regression analysis (not shown). When the forward P/E ratio of the S&P/TSX composite is higher than the S&P 500, the U.S. market was likely to outperform in the next two years.

This chart shows the relative two-year cumulative forward return for Canadian and U.S. equities when the aggregate P/E ratios differ.

For example, the two columns on the far left of the chart show that when the TSX is trading with P/E ratios between four and five times lower than the S&P 500, the Canadian benchmark outperforms U.S. equities by about 10 per cent in the next 24 months.

The trend is clear. When the S&P/TSX composite trades with lower P/E ratios than the S&P 500, outperformance is far more likely.

The reverse is also true. When the Canadian index has a higher P/E, as it does now, the domestic market is likely to underperform. On average, when the TSX trailing P/E is between two and three points higher than the S&P 500, the TSX underperforms the U.S. benchmark by 2.2 per cent in the following two years.

Current forward P/Es tell a more optimistic story. The slightly higher forward P/E of the domestic index suggests Canadian stocks will outperform, albeit by a marginal 2.5 per cent.

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Taken together, the current relative P/E ratios of the domestic and U.S. benchmarks suggest no real advantage for either market. Performance should be similar for the next two years if history is precedence, and this puts an even larger than usual premium on stock selection.

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