The big question: Will strong earnings finally spark a rally on the lagging TSX?

The good news is that a strong Canadian earnings season is shaping up, providing a potential support for domestic stocks at a time of considerable volatility.

The bad news is that nothing has succeeded in igniting the Canadian stock market over the last year – not earnings, not the economy and not oil prices.

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Despite synchronized economic growth here and globally, despite several consecutive quarters of double-digit corporate profit growth, and despite a dramatically improved global market for crude oil, Canadian stocks have failed to keep pace with other developed markets. While the S&P/TSX composite index has lost 0.83 per cent in the past year, the S&P 500 has gained 13.69 per cent, Japan’s Nikkei 225 is up 19.02 per cent, and in Europe, Germany’s DAX and the U.K’s FTSE have risen by 4.01 per cent and 3.56 per cent respectively.

The overhang from NAFTA renegotiations, combined with pipeline politics weighing on the energy sector, have been enough to scare foreign investors away from Canadian equities, said Ryan Bushell, president and portfolio manager of Toronto-based Newhaven Asset Management Inc.

“Internationally, capital just isn’t flowing here. There is a dearth of buyers – it’s a negative feedback loop that’s been in place for a long time,” Mr. Bushell said.

But the disconnect between stock performance, improved economic fundamentals and higher oil prices has at least made Canadian stocks cheap by comparison.

“Ultimately, there is value here, and if the companies are making money, the tide is going to come back in a little bit,” Mr. Bushell said.

First-quarter Canadian results are starting to trickle in, with profits on track for a 14-per-cent increase over the same quarter last year, according to data from Thomson Reuters. The four quarters prior, meanwhile, have seen earnings growth range from 15 per cent to 30 per cent.

Just a handful of companies in the S&P/TSX Composite Index have already reported, with notable earnings beats coming from both Rogers Communications Inc. and Shaw Communications Inc.

Two sectors likely to be the subject of the greatest investor scrutiny, however, are financials and energy.

U.S. bank results so far have hinted at some stateside support for Canadian banks. U.S. corporate tax cuts and higher stock-trading activity amid market volatility drove combined first-quarter profits for the four biggest U.S. banks – JPMorgan Chase & Co., Wells Fargo & Co., Citigroup Inc. and Bank of America Corp. – to the highest level in more than a decade. That bodes well for profits generated from the U.S. operations of Canada’s big banks.

Investors, however, seemed unimpressed by soaring U.S. bank profits, with the immediate share price reaction decidedly negative. Markets will be watching to see if the same trend holds when Canadian banks report earnings later on in May.

“The lack of a positive response to earnings beats would confirm investors’ worries about flat yield curves on this side of the border as well,” said Martin Roberge, a portfolio strategist at Canaccord Genuity.

In both Canada and the U.S., the gap between long-term and short-term yields on government bonds has narrowed recently, which can be an early signal of looming market and economic weakness. Banks in particular, which borrow at short-term rates and lend at long-term rates, tend to profit more when that gap is wider.

But Canadian financials at least have valuation on their side, as does most of the domestic stock market. Trading multiples, on average, have shrunk in Canada’s Big Three sectors – financials, energy, and materials. All three are trading at or below historical averages, Brian Belski, chief investment strategist at BMO Nesbitt Burns, said in a recent note.

“However, we continue to believe the pessimism is misplaced and investors should expect another year of positive stock market performance, despite all the concerns about domestic growth, NAFTA, oil prices, and weak gold prices,” Mr. Belski said.

The oil patch in particular has seen a considerable divergence between share prices and macroeconomic fundamentals in recent months, as the price of U.S. crude oil has approached the US$70 mark.

“Investors appear to have thrown in the towel on the sector as the many headwinds now seem insurmountable,” Mr. Belski said.

The interprovincial fight over Kinder Morgan Inc.’s proposed expansion of the Trans Mountain pipeline hasn’t helped inspire investor confidence in the energy space, which has been beaten down in recent months by a shortage of pipeline capacity and a sizable discount on the price of Canadian crude oil.

Even as the global price of oil has increased by about 40 per cent in Canadian-dollar terms over the last six months, the energy sector within the S&P/TSX Composite Index has been roughly flat.

“The fundamentals got a lot better, and the stocks have done nothing,” Mr. Bushell said.

Over the last three weeks, Canadian energy stocks have finally shown signs of life, with an increase of nearly 9 per cent. A strong earnings season could add some momentum and get investors once again interested in the sector, Mr. Bushell said.

“The generalist investor has to recommit to the space, and see returns being made here. If there is some good visibility from earnings, that might get them onside.”