Gluskin Sheff chief economist David Rosenberg.Deborah Baic/The Globe and Mail
Canadian stocks are no longer looking so attractive relative to south of the border, according to David Rosenberg.
Inside the Market readers may remember the Gluskin Sheff chief economist, who rose to investing fame by becoming one of the first to forecast the recession of more than five years ago while at Merrill Lynch, started this year with the view that the Canadian market was trading at an "epic" discount to the U.S.
His contention was based on the PEG ratio. Popularized by legendary U.S. fund manager Peter Lynch, it's calculated by dividing the price-to-earnings ratio by earnings growth rates over a specified period of time. The lower the PEG ratio, the more a security or market may be undervalued given its earnings performance. Generally, a PEG ratio of 1 or less signals a potential buy for investors. A ratio well above 1 suggests a security or market is richly priced.
Back in February, when looking at the three-year price-to-earnings against the three-year consensus earnings per share growth rates, the TSX PEG ratio was at about 0.92 times. The S&P 500 was at a much higher 1.33 times.
Mr. Rosenberg's call, therefore, that Canada had more upside potential was on the mark; Canadian stocks have tripled the gains of the U.S. in the past year.
But the three-year PEG ratio for the TSX is now at 1.16, up from 0.93 just a month ago. The S&P 500 has moved in the other direction, to 1.26 from 1.42.
"Most, though not all, of the valuation attractiveness of the TSX had commanded over the S&P 500 has vanished in recent months," Mr. Rosenberg points out today in his Breakfast with Dave newsletter. "Quite the swing in relative valuation gaps, and both markets are now within striking distance of each other."
Breaking down the PEG ratio further, Mr. Rosenberg finds that energy and financials are near fair value in Canada, while telecom, utilities, and consumer staples are looking a tad expensive. Industrial, consumer discretionary and health care all have PEG ratios below 1 - an indication that they are going cheap.
Within the S&P 500, the sectors with the most compelling PEG ratios are technology, health care, consumer discretionary, and materials, Mr. Rosenberg said. But energy, consumer staples, financials, telecom and utilities all trade at very steep premiums relative to their earnings growth outlook.
Valuations have been a concern for some time now in both Canada and the U.S., given the persistency of the bull run and lack of a meaningful correction.
Mr. Rosenberg notes that the pullback in the market over the past week, along with analysts revising earnings expectations higher as second-quarter results flood out, are both helping a bit to restore valuations to more attractive levels.
Three-month analyst earnings per share revision ratios for the S&P 500 have gone from 0.71 in April to a three-year high of 1.11 in July (a ratio greater than 1 means that there are more upward revisions than downward.)
The industrials sector in the U.S. has really improved, going to 1.13 from 0.63 in April, and is now at the highest it's been since June 2012. Health care and tech also have shown considerable improvement. The areas lagging the most are utilities, telecom, and consumer staples.
In Canada, forward earnings per share estimates are starting to move up the most now in energy, industrials, consumer staples, and technology, said Mr. Rosenberg. Materials, consumer discretionary, health care, financials, telecom, and utilities are seeing their outlooks stabilize or even dip.
All this adds up to not an especially bearish view of the market right now and Mr. Rosenberg certainly isn't using the term bubble. But some of his research has led him to conclude that it will take roughly a 10-per-cent price correction to eliminate excess valuations in North American stocks.
Darcy Keith