A tale of two stories for U.S. Market entry

Last time I wrote about the S&P 500 was in January. The comparisons were much the same as today. P/E’s were similar and news was improving but we had just come off a drop in the Canadian dollar relative to the U.S. and the market had pulled back from the start of 2010.

Looking at XSP iShares, which is a replication of the return of the S&P 500 hedged in Canadian dollar terms, we can see it is continuing to roar upward. Even though the Canadian dollar has increased relative to the U.S. dollar the XSP iShares fund has still managed to earn almost 40% over the past year. The Canadian dollar has managed to rise over 20% also so unhedged the S&P 500 has increased around 60%. From a technical perspective the current price has lots of support above the 50, 100 and 200 day moving average. Relative strength and MACD are both positive and the moving averages are all rising. All are bullish indicators however the market may be overbought. Keep in mind since this bull rally began in March last year we haven’t seen a significant correction of 10% or more.

In an InvestorsInsights.com, John Mauldin’s article, “US stock market returns – what is in store” examines research done by Dr. Prieur du Plessis of Plexus Asset Management. He looked at what historical returns were over various periods based on what stock market valuations were in their respective time prior to that period. The end goal was to determine the most likely direction of stock prices. P/E ratios and their corresponding 10-year forward real returns were examined. With P/E ratios greater than 21 the average 10-year forward real return was 1.3% with a minimum of -5.9% and a maximum of 7.5%. The analysis strongly showed that there was a downward trend in 10-year forward real returns as P/E ratios increased from less than 6 to higher than 21. According to Robert Shiller of the Department of Yale Economics, the current P/E ratio for the S&P 500 is 21.69. The mean average since the 1800’s is 16.36, the minimum P/E was 4.34 in December 1920 and the maximum was 44.20 in December 1999.

There are good reasons to expect some retrenchment in the U.S. market but if you are going to enter the U.S. market at this point, there are two ways to look at how you can invest in the U.S. With the outlook for the Canadian dollar continuing to improve, XSP will likely underperform as an unhedged investment in the U.S. Further to this, if we have what John Mauldin terms a “muddle through” economy in the US where the markets go sideways because of currently high valuations and the problems with the economy, unhedged individual positions will allow you to trade the securities on rallies and reversals. On the other hand, if we get another market sell off and people flood to U.S. dollars then XSP will shine relative to an unhedged position. In Canada we don’t have the breadth or depth in terms of investment choices and some things cannot be had here so exposure to the U.S. can be an important part of a diversified portfolio despite all the reasons to stay clear of the U.S. Depending on your strategy and view of market direction, XSP may or may not be a good choice.