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Canadian stocks aren't the bargain they're cracked up to be

Are Canadian stocks a safer, cheaper alternative to their U.S. cousins?

Many people, judging from my e-mail inbox, appear to believe so. They're completely invested in the domestic market and have no interest in venturing outside Canada's borders.

But let's take a closer look at the evidence.

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The strongest argument in favour of Canadian stocks is that they haven't soared to the same extent as their U.S. counterparts.

Over the past five years, the S&P/TSX composite, Canada's benchmark index, has produced a total return of 7.3 per cent a year, a respectable, but not overwhelming payoff.

In comparison, the S&P 500 in the United States has rewarded its investors far more lavishly, with sizzling returns of 20 per cent a year, on average. (Both figures are calculated in Canadian dollars and assume you reinvested your dividends.)

The gap in performance has been so huge it's natural to assume Canadian stocks must be considerably cheaper than their U.S. rivals. That impression is buttressed when you compare the stratospheric valuations of flagship U.S. stocks, such as Inc. or Netflix Inc., with the far more conservative prices on, say, Canadian banks. Amazon trades for more than 340-times earnings; Royal Bank of Canada changes hands for 14 times profit.

But impressions can be misleading. Sure, nosebleed prices on the U.S. tech giants are grounds for concern, but most U.S. stocks are nowhere near as highly valued.

One of the most rigorous attempts to compare Canadian and U.S. stocks comes from AQR Capital Management, a Greenwich, Conn.-based asset manager known for its math-driven research. AQR publishes regular updates on its outlook for stocks around the world.

The company's most recent update uses two approaches to evaluate the appeal of different stock markets. One approach is based on corporate earnings adjusted for the business cycle; the other examines dividend yields and the pace of stock buybacks and stock issuance.

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AQR combines these two techniques to arrive at its forecasts. It calculates that Canadian stocks should produce after-inflation returns of 3.9 per cent a year over the next five to 10 years, while U.S. stocks should generate 4 per cent annual real returns.

Any stock market forecast is imprecise and AQR cautions against interpreting its forecasts too literally. Still, its findings suggest there's not a whole lot to choose between the two markets.

If you're looking for better value, the AQR numbers point in the direction of Australian or British stocks, both of which appear likely to produce real returns of slightly more than 5 per cent a year. Emerging markets also look somewhat cheap. They are geared to produce around 4.7 per cent annual returns after inflation.

The major takeaway from all this is that Canadian stocks do not seem poised to produce radically better results than their U.S. or international rivals. To be sure, Canadian stocks may offer some tax advantages to Canadian investors when it comes to the treatment of dividends in taxable accounts, but they're not exempt from threats.

Right now, the biggest single danger is the state of Canadians' wallets. Canadian households are among the most indebted in the world, according to the Organization for Economic Co-operation and Development. Canadian housing prices look exceptionally expensive when measured against either incomes or rents, according to the International Monetary Fund.

These weaknesses are nicely summed up in the Vulnerabilities Barometer, introduced by the Bank of Canada late last year. It shows the risks posed by companies, banks, housing and households, and tallies them all on one neat chart.

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The message of the barometer right now, according to Eric Lascelles, chief economist for RBC Global Asset Management, is that Canada's banking and corporate sectors are safer than normal, but households and the housing market pose significant risks.

"Collectively, Canada's present financial system vulnerabilities are the worst in the history of the data series," Mr. Lascelles notes. He notes that the central bank's calculations suggest a 36-per-cent chance of a period of financial stress over the next two years.

The same technique applied to other countries shows vulnerabilities are considerably lower in the United States and somewhat lower in Britain (although not in Australia).

The barometer is not a reason to flee Canada, but it should cast doubt on the case for seeing Canadian stocks as havens in an uncertain world. Rather than sticking close to home, a better strategy for cautious investors is to diversify globally to reduce the risks from any one country.

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