Dr. Jekyll’s other side: Canada’s market and economy can be alternately friendly and vicious.
The patronizing pats on the head that Americans like to bestow on their nice neighbours to the north can be annoying, but that's the price Canada pays for being one of the more civil nations on earth. We're one of the world's most advanced economies, with a well-deserved reputation for treating people humanely.
The Canadian stock market is another matter.
The S&P/TSX composite's focus on resource stocks makes our asset markets swing in tune to emerging markets, not developed ones. For global investors, Canada is a Dr.-Jekyll-and-Mr.-Hyde nation – outwardly pleasant but with an equity market that can stab portfolios in the back after the sun sets.
The accompanying chart shows the performance since 2003 of the S&P/TSX composite and the MSCI Emerging Markets benchmark. Their correlation – a mathematical measure of how two trends move together – is an astounding 0.95. (A correlation of 1.0 would indicate perfect lockstep. By comparison, the TSX's correlation with the S&P 500 in the United States is a far lower 0.78.)
How is it that a country as economically mature as Canada has an equity market that moves more in line with the South Korean KOSPI index than the S&P 500 or FTSE 100? It's because the S&P/TSX composite bears almost no resemblance to the Canadian economy.
Mining and energy together represent 12.7 per cent of Canadian gross domestic product, according to Statistics Canada. Materials and energy stocks, however, make up 41 per cent of the S&P/TSX composite.
Meanwhile, the auto sector contributes 12 per cent to Canadian GDP. But the car industry makes up less than 1 per cent of the domestic equity benchmark, because most Canadian auto plants are owned by U.S. and Japanese-listed corporations.
The only industry where the TSX and GDP are even in the same postal code is the FIRE sector – finance, insurance and real estate – which makes up 33 per cent of the stock index and contributes 21 per cent to GDP.
It's easy, and common, for investors to confuse the equity market for the economy. The major broker dealers are quite happy to egg them on, hyping the "incredible opportunities" in mining and energy stocks.
It's no mystery why Bay Street is so fond of miners and drillers. The resource industries, along with real estate, have an endless ability to absorb investor capital – and to generate a torrent of fees for the financial services industry. Thanks to the casino-like nature of prospecting and the huge cost of building new mines, the industry's appetite for new money is nearly insatiable. David Einhorn, manager of the Greenlight Capital hedge fund, has said, "Give a miner a dollar and he'll dig a hole." What the miner will not do is tell you the market is already satiated.
Commodity wealth has clearly been a key factor in boosting Canada's prosperity. But investors should keep in mind that commodity cycles have historically resembled a series of round trips, from lows to peaks and back to lows. Investors have to time the resource cycle to make profits – getting in early and back out before Mr. Hyde rears his portfolio-murdering head.
The key economic data points last week painted a horrific picture of Europe and pointed to sluggish activity for Canada, lower than expected growth in China and further signs of recovery in the United States. The continuation of these trends could bring out Canada's Jekyll-and-Hyde nature, with a sunnier economy duking it out with a murderous market.
Equity markets would fall if China's recovery continues to disappoint and commodity prices continue their decline. The domestic economy, however, would pick up as improving U.S. activity boosts sectors such as Canadian auto manufacturing and forestry – both of which have virtually no representation in the equity market but make big contributions to GDP. The market would look like hell while things were actually getting better.
Canada is, for the most part, a kind-hearted Dr. Jekyll of a country. But with an open economy and a resource-heavy equity market highly sensitive to global growth, investors should be prepared for at least one painful bout of Hyde-like volatility in their investment portfolio at least once per decade.
Right now, with copper prices down more than 20 per cent in 2013 and grief counsellors being the only thing missing from this week's downbeat mining conference in Toronto, it's a good time to remember that Mr. Hyde doesn't play favourites.
Scott Barlow