A consistent theme of ours remains that equity investors should look beyond the United States for more attractive risk-reward profiles.
We have just updated our monthly “Strategizer” guidebook for active investors, where we assess each asset class across a variety of metrics that are based on technicals, fundamentals, valuations, sentiment and positioning. Canadian equities flipped to “neutral” from “underweight” – building on four consecutive months of improvement, as our model score rises to the highest it has been in 12 months.
This move has begun to catch our eye and represents a shift at the margin with an important turn in the expected return outlook, making Canada worth a closer look, not only for domestic investors, but for international ones. Indeed, this shift to “neutral” changes expected returns from flat to negative (price only) to just shy of 4 per cent over the coming 52-week period, based on our historical back-testing. Tack on a current dividend yield of 2.4 per cent for the S&P/TSX Composite Index and that brings total return prospects to 6.4 per cent.
Another way to look at it is to use the Gordon Growth Model to calculate potential upside. This aims to calculate the intrinsic value of a stock based upon future dividends that grow at a steady pace.
Based on this methodology, the return outlook for Canada tops the list among some of the largest stock markets on the planet and is in line with the annualized total return for the TSX over the past 40 years of 9 per cent.
There are a number of shorter- to medium-term tailwinds at play for the Canadian market.
First, Strategizer tells us, as of the end of October, there has been a significant improvement in the momentum and technical picture after the September sell-off, with the best one-month progress on this front since December, 2020 – when the value trade surged after the “Pfizer Monday” vaccine news last November.
Second, there has been a considerable reset in positioning and a souring in sentiment – both of which we view as contrarian positive developments.
Lastly, the earnings outlook is being revised higher, as forward 12-month earnings per share estimates have increased by 7.5 per cent over the past three months, which is a historically fast pace. The result is the price-to-earnings multiple, at 15.6 and in line with its historical average of the past 10 years, has held steady despite the October rally.
At the sector level, when ranking each by their recent price trends, fundamentals, valuations and investor positioning, the results spit out a mix of defensive/defensive-growth areas, as well as have some select exposure to the value trade. (“Defensive growth” refers to companies that are able to expand the business independent of the business cycle.) When economic growth is slowing, as is currently the case, and with so many uncertainties surrounding the course of the pandemic still in play (just as cases across Canada begin to tick up again, albeit marginally) there is a benefit to becoming more defensive.
Our preference for this part of the asset mix is in real estate, which has seen the best improvement in its fundamentals over the past four weeks. Its ranking has gone from second-last to best over all when looking at the three-month and year-over-year change in forward earnings estimates, which are up 50 per cent and 40 per cent, respectively.
Materials also screen particularly well, not only because of the sector’s strong profits outlook (third-fastest pace of upward revisions to forward earnings estimates), but it also has the best valuations, including P/E and price-to-sales metrics. The group also offers an elevated share of gold miners (defensive – and prices of the yellow metal are at a five-month high) but also base metals and other cyclical commodities.
For exposure to the value trade, Canada is one of the best countries to take advantage of the surge in energy prices as it represents the second-largest weight in the TSX, at 13 per cent. This sector has the benefit of strong price momentum, relatively light positioning, and screens second-best in terms of improvements in the earnings outlook, as well as valuations. Furthermore, with years of capital discipline being demanded by investors, the limited capital expenditures alongside rising prices in the underlying commodities will result in higher free cash flow and potential dividend payouts to stockholders.
Financials represent a whopping 32 per cent of the overall market and rounds out our preference for exposure on the value front. This group should benefit from a number of singular tailwinds. First, rising oil and gas prices should help release loan loss provisions from the energy sector that were a drag on results prior to this latest price run-up. Second, with regulators clearing the way for larger cash distributions, shareholders can expect a bump up in buybacks and dividends at a time when the sector already commands a 3.1-per-cent yield. Lastly, insofar as the persistent inflationary pressures linger for longer than previously thought, financials can be used as a hedge against any upward move in interest rates.
Despite having reservations surrounding Canada’s longer-term economic outlook – which mostly involve elevated debt at all levels – there are a number of shorter- to medium-term reasons to be looking at the TSX closely. These include a strong price and momentum backdrop, a reset in positioning and sentiment that make the index ripe for a contrarian bounce, and valuations that are in line with historical averages.
In terms of favourite sectors, our preference is for a mix defensive/defensive-growth, as well as select value exposure: energy, financials, real estate and materials. Ultimately, with our belief that the outlook for forward returns remains poor for the U.S. stock market, adding international equity exposure is a prudent strategy.
While Asia has long been a favourite of ours, lately the Canadian market has been creeping up on our watch list and is another option for investors to consider.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Marius Jongstra is an economist and strategist at the firm.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.