Leading the pack, investors wonder how long Canada’s outperform streak can last

Gains may now be priced into the market, analysts warn

The Toronto Stock Exchange facade with office towers, looking toward the sky

So far this year, the TSX has been one of the world’s best-performing equities markets. (Manuel Romaris)

If you predicted at the start of the year that, by July, the S&P/TSX composite would be one of the best performing indexes in the world, you would have been laughed out of the room. After all, our market has underperformed for the past two years. With China’s slowdown still putting pressure on global commodity prices, and America’s plodding recovery, the chances that our market would lead the way seemed implausible.

Yet here we are. Since January, the S&P/TSX composite index is up more than 13%, while the S&P 500 has gained 7% and the FTSE 100 sits just above break-even. The question is whether this Canada rally can continue. The experts remain skeptical. The Canadian market has done well this year, they reason, because the overrepresented materials and energy sectors, after performing poorly in 2013, had nowhere to go but up. Last year, materials fell by 32%, while energy was up just 9%. So far this year, those sectors have climbed 23% and 21% respectively.

“There’s definitely a little catch-up,” says Craig Fehr, Canadian investment strategist with Edward Jones. “Nearly half the index is outperforming, so that’s really helped boost performance for the overall market.”

It also helped that Canada’s market was undervalued compared with America’s at the beginning of the year—15 times forecast earnings versus 16—and that the nearly $40 gap between Canadian crude oil and West Texas Intermediate prices narrowed in the latter half of 2013, says Bob Gorman, TD Waterhouse’s chief portfolio strategist.

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Unfortunately, all the factors that have led to these good returns are now priced into the market. Gorman expects corporate earnings growth will remain solid but not spectacular. The dollar’s not moving much anymore, so we won’t get gains from a lower currency. Commodity prices are not likely to move enough to boost material and energy stocks. In other words, expect only modest appreciation in share prices from here.

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This doesn’t mean you should sell out of your Canadian stocks, but choose your companies wisely, says David Madani, an economist with Capital Economics. While he doesn’t think the Canada rally is finished, he does say other markets will outperform our own in the second half of the year. “Further strong gains would be harder to justify based on price-to-earnings fundamentals.”