By Bhawana Chhabra

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The real story behind Canada's lagging stock market Back to video

The Canadian stock market has been woefully underperforming its U.S. counterpart, but the reason has more to do with sector concentration — Canada is filled with banks and resource-related stocks while the United States is replete with technology and health care — than any commentary about how Corporate Canada is really doing.

If the TSX/S&P composite index enjoyed the same growth orientation in terms of sector shares as is the case with the U.S., the performance gap would be far less dramatic. For investors in the Canadian market, this means that until such time as value stocks begin to outpace the growth universe, the prudent thing is to overweight the smaller sectors with better growth and valuation profiles (technology, staples, industrials and health care) and underweight the rest.

We analyzed the contribution of each sector to the headline index and how it would have looked had the S&P/TSX composite index mimicked the weightings of the S&P 500. The underperformance by the S&P/TSX composite comes despite favourable valuations, trading at a 12-month forward P/E of 14.3x and a 6.4 multiple point discount to the S&P 500 (the long-term differential is 1.6 points).

Old economy vs. new economy

The big difference between the two comes down to the “old” economy versus “new” economy stocks. Technology and health care make up 43 per cent of the S&P 500 (versus nine per cent in the S&P/TSX composite), while financials and energy account for 48 per cent of the composite (compared to 16 per cent for the S&P 500). Simply put, the composite index is more cyclical/value-oriented, while the S&P 500 is tilted toward growth.

Since the October 2022 lows, equity markets have been in an environment where growth has outperformed, but despite the valuation differences, the S&P/TSX composite has not been rewarded as a result. If we put the index on a more comparable footing, it would be trading at 24,500 and not 21,300 currently (or 15 per cent higher). This means the composite would have been up roughly 35 per cent instead of the 17 per cent rally that occurred, bringing the gain off the lows much more in line with that of the S&P 500 (42 per cent).

Understanding the key differentiators has implications for sector allocation within U.S. and Canadian equity portfolios. Some of key standout factors include:

• The S&P/TSX composite technology sector (up 106 per cent since the October 2022 lows, but with a current weight of roughly nine per cent) has outperformed its S&P 500 counterpart (up 83 per cent, current weight of 30 per cent), but the size difference in their respective indexes has led to diverging impacts at the headline level.
• Financials, health care, consumer discretionary and real estate had directionally similar performance in the S&P/TSX composite and the S&P 500.
• Consumer staples is another interesting sector, where the Canadian returns are almost three times the S&P 500 (29 per cent in the S&P/TSX composite versus 12 per cent in the S&P 500 since Oct. 12, 2022). The answer to this lies in a superior growth profile, and a lower P/E in the Canadian sector to boot.

But there are a few notable dissimilarities too, which eventually boil down to the company profiles in those sectors:

• The biggest divergence comes from communication services, which has accounted for a fifth of the S&P 500 gain, but a negative contribution in the case of the S&P/TSX composite (currently a nine per cent weight in the S&P 500 and four per cent in the composite). Within the S&P 500, communication services is home to two of the Magnificent Seven names (Meta Platforms Inc. and Alphabet Inc.), while the S&P/TSX composite is comprised of “old” economy telecom companies ranging from Rogers Communications Inc. to Telus Corp., offering a much lower growth trajectory.
• The second-largest contributor to the divergence is materials, where the S&P/TSX composite sector has had a decline of five per cent while the S&P 500 counterpart is up 26 per cent. Here as well, exposure at the industry level significantly varies. The S&P/TSX composite’s sector is mainly metals and mining, which bears the brunt of weaker commodities prices due to lacklustre global growth and deflationary headwinds from China. The S&P 500’s materials sector has a higher concentration of chemical companies, where the underlying prices have held up better than their metal counterparts.

Sector composition

Another way of explaining the divergence is through the growth and valuation profiles of the respective indexes. Earnings per share is expected to grow 9.5 per cent year over year this year for the S&P 500, while the S&P/TSX composite is expected to decline by roughly three per cent. A lower growth profile should theoretically warrant the valuation discount that is present between the two indexes, but it once again comes down to sector composition. The growth profile is being weighed down by the largest sectors in Canada.

All in, the S&P/TSX composite’s weaker performance has been underlined by its much lower exposure to the high-growth tech sector, and outsized exposure to energy, materials and financials (all of which are expected to have earnings declines in 2024).

Until the market environment switches towards a more favourable value/pro-cyclical backdrop, Canadian underperformance will continue by design — it just comes down to math. That makes buying the headline index difficult at this time, so investors would be better off overweighting the sectors in the S&P/TSX composite with better earnings growth and valuations compared to the S&P 500 — such as technology, consumer staples, industrials and health care.

Bhawana Chhabra, CFA, is a senior market strategist at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.