Learning to love the S&P 500

A few weeks ago the Information Management Network invited me to participate in its annual Canada Cup of Investment Management in Toronto. The topic was, A Review of the Global ETF Landscape.

I was skeptical because ever since the 2007-08 financial crisis, the global equity stock bourses seemed to be operating on a monkey-see monkey-do basis. What was the point of scanning the global universe of exchange-traded funds for opportunity if they were all doing the same thing at the same time?

In preparation, I put together a basket of ETFs that would represent the major global sectors by geography and classification. For sectors by geography, I selected Europe, Asia Pacific, Latin America, the United States and Canada.

For classification, I broke the global landscape into mature markets such as the U.S., Canada, Germany, the United Kingdom, France and Japan. For the emerging economies, I included ETFs exposed to parts of Latin America, Eastern Europe, Southeast Asia, Russia, India, and China.

I settled on a total of 40 diverse ETF selections and ensured that all had at least one year of trading on either the Toronto or New York stock exchanges.

I then proceeded to do a routine performance study by comparing the price performance of each global ETF relative to the MSCI All Country World Index, which is designed to measure the equity market performance of 24 developed markets.

I assumed my ETF basket to be a highly correlated group that would operate together to trace out the same path as the broad ACWI.

To my great surprise, I discovered the global markets were not operating on a monkey-see monkey-do basis. Over the past year the strongest global markets on a relative basis were in the U.S. large and small cap space. The bad news for Canadian investors is that along with the mature European bourses, Canada was among the weakest markets on a relative basis.

The good news is that when performance deviation between the various global markets is operating, there is also opportunity for investors.

For example, if we know that U.S. equities have outperformed Canadian equities over the past 12 months, then we simply wait for the relationship to change and then react by increasing our Canadian equity exposure.

Keep in mind this is a study of relative performance and not abso- lute performance. In other words, in spite of poor relative outperformance in late 2009 through early 2010, the S&P/TSX composite index was still advancing. Before we do some technical work on the changing relationship between the U.S. and Canadian equity markets, it is important to understand why these price deviations occur from time to time. The sector weights of the S&P 500 index are relatively balanced, with five out of 10 sectors (technology, financial, health care, consumer staples and consumer discre- tionary) making up about 68 per cent of the index by capitalization weight. The sector weights of the Canadian S&P/TSX composite index are not balanced, with three out of 10 sectors (financial, energy and materials) making up about 68 per cent of the index by capitalization weight. It is the energy and materials sectors that make the S&P/TSX composite index so commoditysensitive, and we know that commodity prices have been under pressure for months due to fears of a pending global growth slowdown.

The technical work on the changing relationship between the U.S. and Canadian equity markets is quite easy to do online.

Go to the home page of stockcharts.com. In the upper right blue box, select “1. Choose a type of chart” and choose Gallery View in the drop-down menu. Then select “2. Enter a symbol,” type in $TSX and click Go.

Three charts will appear. Scroll down to the middle weekly chart and observe the two squiggly lines at the chart’s bottom (also shown in our chart at the left). That shows the S&P/TSX composite index’s relative performance versus the S&P 500 curve.

The fast squiggly black line is a ratio of the S&P/TSX composite over the S&P 500; when the black line trends downward, the S&P/ TSX composite is weaker than the S&P 500, and vice versa. The slow line that crosses through it is a 20-period moving average of the fast line.

The S&P/TSX composite index will generate an outperformance signal when the ratio’s fast line crosses above the slow line and when the slow line also turns upward.

So far, there is no pending improvement in the Toronto Stock Exchange versus the S&P 500, so in the interim, be patient and enjoy the relative strength of the U.S. markets. Bill Carrigan, CIM is an independent stock-market analyst.