TSX deep dive

RYAN   By Guest Blogger Ryan Lewenza


I was recently trashed in the comments section, something I’ve had to get used to on this merciless blog. The angry commenter derided me for focusing my research and commentary on the US economy and S&P 500. So today I provide a deep dive on the S&P/TSX Index (TSX) and hopefully atone for my sins and gain sweet mercy from said commenter.

Here it goes…

The TSX has kind of sucked in recent years, especially relative to the US equity markets. For example, the TSX has returned 4.4% annually over the last five years, less than half of the S&P 500 at 10.7%. Longer term (e.g., 20 and 30 years) the TSX has also lagged behind the S&P 500. So what gives?

Long-term Equity Returns

Source: Bloomberg, Turner Investments; as of June 28, 2020

A big reason for the underperformance has been due to our devastated energy sector. I’ve spoken ad nauseam about this and how I believe we need a more supportive Federal government and the darn Trans Mountain pipeline expansion so we can have more than just one buyer for our oil (the US buys 99% of our oil exports, which given the US shale revolution means less demand for our oil).

Below I show the connection between the TSX and oil prices by charting the year-over-year percent change in TSX earnings and WTI oil prices. Note the correlation and how declining oil prices generally weighs on TSX earnings. Given this relationship, we need oil prices to rebound strongly for the TSX to really start moving again. On a positive note I see oil prices possibly getting into the US$60s next year as demand recovers but I don’t see US$80-$100/bbl any time soon.

Oil Prices and TSX Earnings

Source: Bloomberg, Turner Investments

Another reason the TSX has lagged behind the US is more about what we don’t have in the TSX – information technology, consumer discretionary, and healthcare stocks. These have been some of the best performing sectors in recent years, which given the combined weight of 14.8% of these sectors in the TSX versus 53% in the S&P 500, this also helps explain the TSX underperformance.

Let’s face it, the TSX remains a financials and resources driven index with those sectors representing 56% of the TSX. The good news is I see Canadian banks doing a lot better next year as the economy rebounds and credit losses peak this year. Combined with my expectation for a slow recovery in oil prices, 2021 is looking a bit better for our equity Canadian markets.

TSX Sector Breakdown

Source: BMO ETFs, Using ZCN as proxy for the TSX

Another big positive for Canadian equities are their cheap valuations. Below I chart the TSX price-to-book ratio (P/B) and currently it’s trading near a 27-year low of 1.5x, well below the long-term average of 2.2x. In contrast, the S&P 500 trades at a high P/B ratio of 3.5x. While we’re still bullish on the US equity markets and have a good weighting to the region, we are keeping a mindful eye on those elevated valuations.

S&P/TSX Price-to-Book Ratio (P/B)

Source: Bloomberg, Turner Investments

Even better, at the March lows the TSX fell below the magic 1.4x P/B level. I say “magic” since every time the TSX traded down to these dirt-cheap levels (09, 04, 98 and 95) we saw the TSX deliver great subsequent returns.

From the table below you can see that the TSX returned on average 27% over the next 12 months and 68% over the next 24 months, when it traded down to this 1.4x P/B level. If history repeats, we could be looking at some good returns over the next few years.

Basically, the TSX underperformance has compressed valuations to the lowest level in years, which could be setting the stage for much better returns in the years ahead.

TSX Returns After it Drops Below 1.4x P/B

Source: Bloomberg, Turner Investments

One final consideration for Canadian equities and the TSX is the attractive dividend yield it offers. Currently the TSX yields 3.5%, in large part due to the sweet 4% dividend yields offered by the big banks. Compare that to the S&P 500 yielding 1.7% and government bonds below 1%. Add in the tax advantage of Canadian dividends versus US and international equity dividends, Canadian stocks look more and more attractive each day.

S&P/TSX Composite Dividend Yield

Source: Bloomberg, Turner Investments

Ok that was a lot of numbers and boring information about sectors, valuations and dividend yields, so the key takeaway of today’s blog is that the TSX has underperformed in recent years, but I believe this underperformance could be setting the stage for a much better decade ahead. For our clients we continue to invest 2/3rds of their equity exposure in the US and international markets, but there could be a day when we decide to trim this back and beef up our TSX weight given some of the factors I highlighted today.

Now let’s see if that blog dog commenter throws me a bone and appreciates today’s topic on the TSX. I’m not holding my breath!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.



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