Time to cash in on Canada?

(August 26, 2005) With oil prices hitting record highs, it’s no surprise that the energy-heavy Canadian stock market has outperformed other world markets this year. But should investors be favouring Canadian equities to take advantage of those soaring energy prices, or is it time for some profit-taking?

Those are the questions posed by CI fund manager William Sterling in a recent commentary on oil prices and stock market movements.

“Emotion argues for the former,” Sterling says. “Canadian equities have done exceptionally well relative to world equities the past few years. Let the trend be your friend. However, basic investment logic, i.e. buy low, sell high, argues for the latter.”

Sterling says historical data supports the case for diversification, noting that the world market has tended to outperform when oil prices decline and that Canada outperforms when oil prices rise. That’s certainly been the case of late: the S&P/TSX Composite Index is up nearly 14% year-to-date, while the MSCI Global Capital Markets Index has risen just 1% since the beginning of 2005.

“Simple statistical analysis shows that movements in the price of oil have explained about two-thirds of movements in the world versus Canada performance gap over the past 25 years. This is an extremely strong relationship.”

Still, Sterling says the Canadian market is by no means a one-trick pony. “There is another one-third of the performance gap that cannot be explained by movements in the price of oil. However, clearly oil matters a great deal in forecasting whether the Canadian market is likely to outperform the world market going forward.”

And although momentum could drive oil even higher, Sterling expects prices to moderate, eventually. Several experts are warning that China’s oil demand may turn out to be overestimated as the country brings in more coal-fuelled generating plants, he points out.

And there are other reasons for investors to think about reassessing the amount of foreign equity in their portfolios now that the foreign content rule has been eliminated. The Canadian dollar is no longer undervalued against other currencies as it was a few years ago, Sterling notes. In addition, valuations in many foreign equities look quite attractive, he says, with European equity markets trading at around 12 times forward earnings and Asian markets (outside Japan) trading at around 11.5 earnings.

“It may be that this time is different, but in the time-honoured tradition of ‘buy low, sell high’, we think investors should consider using periods of high prices to reduce exposure to Canadian equities relative to world equities,” Sterling concludes.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com