Should Canadian investors go shopping in the US?

This piece caught my attention over the weekend:

Here's why Canadian investors should go shopping in the US: U.S. stocks have been discounted, and with a strong Canadian dollar there are bargains to be had.

Now, WCI is most definitely not the place you turn to for financial advice, but there are some things going on here that deserve a closer look. For example, how do we distinguish between a stock that is 'cheap' from one that is 'worth less'?

Probably most crucial factor to consider in cross-border stock shopping is the exchange rate. From a Canadian investor's perspective, an increase in the CAD reduces the value of USD-denominated assets. A USD purchased at a 0.62 exchange rate had lost 43% of its value when the CAD peaked at 1.09. Here is a graph of the TSX and the S%P500 indices in both CAD and USD terms, scaled so that January 1999 = 100:

Canadians who have hung on to their USD assets over the past decade probably regret doing so. Here are the CAD-denominated y/y changes for the two indices (these are all ex-dividend and are not the actual rates of return):

For most of this period, Canadian investors who chose the S&P500 over the TSX regretted this decision a year later: the average gap in these two series was 11%.

But there have been important episodes where shifting to USD assets would have been a good move, namely, just before a recession. An asset that pays relatively well in bad times is the sort of correlation you like to see, and investors would be willing to accept lower average returns to hold it. But 11% /yr seems to be an awfully big risk premium.

Okay, we should look further back. Here is a graph of y/y changes in the TSX and the S&P500 in CAD terms, using monthly data:

If we go back further, there are more and longer episodes where the S&P500 outperformed the TSX in CAD terms. These generally coincided with periods where the CAD was depreciating. Here is a graph of the differences in y/y changes against the changes in the exchange rate:

So here's what Canadian investors should be thinking about in their deliberations over whether or not to buy those USD-denominated assets:

• In the short term, are you willing to bet that anticipated USD returns will be high enough to compensate for the losses generated by a possible CAD appreciation?
• In the longer term, what is the risk premium you are willing to sacrifice in order to hold USD assets that will generate a higher return the next time a crisis rolls around?

I suppose that from the way this post has evolved, it's evident that I'm somewhat skeptical of the merits of  buying up 'cheap' USD-denominated stocks. There may well be many individual stocks that will pass these tests, but investors should be aware of the extent to which this strategy consists of betting against an appreciation of the CAD. And these days, you're going to have to come up with a really good story for why the CAD will not appreciate to parity and beyond.

Comments

[RSJ]

My "story" is that the CAD is riding on a commodity bubble that will burst. AUD is in a similar position. For those who have ridden these commodity prices up a bit, it may be worthwhile to take some profits and diversify into something not driven by Chinese pig farmers and metals speculators.

Which is not to say that USD is the only option -- why not also look at Japan, or european equities, for example? This is not investment advice, but a caution that holders of CAD assets may be less diversified than they think.

[Mike Moffatt]

"And these days, you're going to have to come up with a really good story for why the CAD will not appreciate to parity and beyond."

A significant appreciation in the USD (relative to the CAD) is always possible. I defy anyone, however, to argue for the claim that an appreciation is more likely than a depreciation.

Great post!

[Just visiting from Maclean]

I defy anyone, however, to argue for the claim that an appreciation is more likely than a depreciation.

Maybe you should ask the guy at the aerosal spray can company who is doing the financial forecast for the argument:

For simplicity assume the company pays back $100 000 a year for 10 years and the useful life of the machine is 10 years...It is expected that the Canadian dollar will trade for, on average, 90 cents U.S. during this period...

[Mike Moffatt]

HA! I knew I should have picked different numbers for my example.

[Patrick]

One can always buy ETF's or mutual funds that hedge currency risk for you.

[Kosta]

Great post Stephen, thanks!

[Cumudgeon]

Investing in the US isn't a particularly good idea unless you really know what you're doing and you can afford to take severe losses. US markets are very badly regulated and there's very little assurance that whatever you put your money into won't turn out to be the next Enron, Worldcom, Madoff Scam, or "AAA" subprime-based MBS. If you value your money, invest somewhere that's better regulated.

[westslope]

That's a very nice framework for thinking about the Canada-USA portfolio split.

Given the tendency of multi-national companies to price-to-market, there always tends to be good deals to be had for cross-border shopping consumers after sudden exchange rate movements.

As for investing, I see opportunities in the USA that could outstrip any US dollar depreciation though I'd say there is a 50%+ chance of the Canadian dollar depreciating in the near-term.

In my case, I have wanted to diversify into hi-tech, especially a couple of hi-tech Israeli companies (that also manufacture weapons) but instead have found oil exploration and production (e&p) companies too tempting, in particular, a couple of US-based companies. Production growth or speculative share price runs anticipating wild cat well results are more than enough to off-set currency risk. Besides, the US derivative markets are more liquid, and can be used to hedge core positions or make highly-levered bets.

For conservative investors, there were still some blue-chip, dividend-paying deals in the USA last time I looked. Telcomm/wireless providers for example. The pipeline company Kinder Morgan looked sweet. Mind you, if I was an American-based ETF buyer I would look to trading out in a few months as this current bull run will not last and many Johnny-come-lately fund managers are piling into the market right now.

And, in answer to that question that some of you surely have, are oil prices higher than what traditional market fundamentals would support? Yes. Most definitely. As the MERT suggests, the Canadian dollar could sharply decline in value if the price of benchmark oil drop to US$60 from US$85/barrel. My oil bets could still increase in value based on growing production and reserves. With few exceptions, most e&ps are earning significant rents at US$50 to US$60/barrel.

[Mike Moffatt]

"And, in answer to that question that some of you surely have, are oil prices higher than what traditional market fundamentals would support? Yes. Most definitely. As the MERT suggests, the Canadian dollar could sharply decline in value if the price of benchmark oil drop to US$60 from US$85/barrel. My oil bets could still increase in value based on growing production and reserves. With few exceptions, most e&ps are earning significant rents at US$50 to US$60/barrel."

I hope you're right. Oil just hit $86.70 and the loonie hit $1.00 this morning (MERT value = $1.0210). 85% of what we sell in my company we export to the U.S., so I feel like crawling back into bed.

[westslope]

Mike: Sorry to hear that.

BTW, does your company top brass pay attention to your MERT model and, perhaps, strategically plan and hedge accordingly?

[Just visiting from Maclean]

westslope: How would company top brass use the model? From what I understand, it doesn't predict future exchange rates, just what the current one should be - or am I missing something here?

[miko]

The stock market affects a lot of people, myself included, so I actually appreciate a little financial commentary every once in a while from people who actually know what they're talking about. I'm also curious about the net effect that an appreciating Canadian dollar has on the Canadian economy. I know it hurts companies like Mike's, who make most of their money in exports to the US, but I imagine that a company who buys most of its supplies from the US would be benefited by a strong CAD. I think we could also afford more imported goods as a nation. So is it a wash? Or does one effect dominate?

[westslope]

westslope: How would company top brass use the model? From what I understand, it doesn't predict future exchange rates, just what the current one should be - or am I missing something here? -Just visiting

Good call; you are absolutely correct. My bad. I'm the one reading too much into the model's potential application. And though I suspect that oil prices are easier to predict than exchange rate movements, I have no empirical proof that is the case. (Future prices might be unbiased predictors but that doesn't mean that oil prices can be cost-effectively forecast.)

Now an employee in Mike's position could do some extra research, go to the bosses and say: Well it looks like oil (and other commodity) prices are going higher, we should prepare for a stronger Canadian dollar. But the model by itself contains no such potential insight.