Canada’s Benchmark Stock Index Refuses To Yield

Yesterday, the S&P/TSX Composite Index closed at 12,321.73. So far, in 2006, the index gained 9.5%. Last year, it gained 21.9%, the year before that 12.4%, and the year before that 24.3%. From the historical perspective, such a steady growth rate was often equated with the market’s gross overvaluation.

However, a study investigating the relationship between stock prices on the TSX and companies’ earnings over the past quarter of the century provided a somewhat unorthodox answer. As it turned out, stocks listed on the Toronto Stock Exchange are neither cheap nor expensive–but, actually, priced just about right!

Apparently, the TSX is currently trading about sixteen times its estimated future earnings for the next 12 months. Note that the 25-year average sits at about 16.2. And just as an illustration, who can forget the peak of the tech bubble in 2000, when stocks traded more than 25 times their forward price-over-earnings.

If you recall, fairly recently, one by one, editors at PROFIT CONFIDENTIAL tried to drive home a simple, yet profitable investment strategy–buy Canadian stocks, particularly shares in companies engaged in mining and exploration of precious metals and oil.

This time around, we are adding one more reason why you should buy Canadian stocks–their very attractive valuations. It is quite true that stocks have posted significant gains in the past three years. However, earnings have gained even more. For example, since 2002, the S&P/TSX benchmark has posted a gain of whopping 120%. By the same token, earnings posted an even more amazing growth rate of 160%!

In contrast, during the tech bubble from 1994 to 2000, the benchmark posted a return of 184%, while earnings increased a measly 61% in comparison. Unfortunately, we all still carry painful memories of how this particular divergence resolved itself.

The best part about the S&P/TSX Composite is that the index is expected to increase another 14.2% by the end of 2006. Of course, most of the gains will be delivered by the energy and materials sectors, about 40% to 50%.

At this point, it seems prudent to have certain caveats in place. First of all, what you have read so far is just one person’s opinion, which may or may not be realistic. Second, energy prices may hurt the index even if oil declines too sharply or rises too steeply.

Spiraling down energy prices could create very real fiscal problems for a number of Canadian oil and gas explorers. Although oil and gas appear pretty hot right now, bear in mind that the market has already absorbed most of the positive impact. On the other hand, if energy prices go up way too much, there is a very real risk that global economies would come to a grinding halt.

Two days ago, investors north of the border got their first taste of just how bad things could get if oil prices decline sharply. In a single day of trading, oil shaved about 2.5% off of its price. This drop was prompted by OPEC’s announcement that its members are producing plenty of oil. Not far behind were precious metals producers, whereby gold lost 1.8% and silver “slipped” 9.2%.

Still, Canadian stock markets remain relatively undervalued, and with attractive P/E ratios. Meaning, seeing as the next earnings season is just around the corner, more profits seem to be in the cards.