Canadian Equities and Emerging Stock Markets

To international investors, investing in Canadian equities amounts to investing in banks and natural resource companies. Currently, the largest sectors on the TSX (in terms of market capitalization) are  financial services (32%), energy (25%) and raw materials (18%). These three sectors account for a whopping 75% of the TSX. The performance of the TSX depends, to a large extent, on the demand for natural resources.

Here is a chart comparing Canadian equities with equity markets in Europe and the Far East (EAFE), emerging markets (EM) and the United States (USA). The data are in US dollars, include dividends and cover the period January 2002 to November 2012. Notice that each equity index tends to peak and trough around the same times but in terms of performance, emerging markets and Canada are the two big leaders.

In order to determine how well movements in Canadian stock prices can be explained by movements in other major equity markets, I fit an autoregressive distributed lag (ARDL) model. Here are the regression results.

The model fits well. Residual diagnostics (not shown) indicate serial correlation in the residuals or squared residuals is not a problem. The plot of actual values vs fitted values shows how tight the fit is. The variables are transformed to natural logarithms which helps to reduce the variability in the data. The natural logarithm transformation also means that the coefficient estimates can be interpreted as elasticities. The largest contemporaneous effect comes from emerging markets (estimated coefficient of 0.54 with a p value of < 0.01). The estimated coefficient on US equity markets is positive and statistically significant at 5% but 47% smaller than the estimated coefficient on emerging markets.

Emerging markets (EM) has the largest short-run elasticity. In the short-run, a 1% increase in EM stock prices increases Canada stock prices by 0.54%. Emerging markets also has the largest long-run elasticity. In the long-run, a 1% increase in emerging market stock prices increases Canadian stock prices by 0.76%. Long-run EAFE and USA elasticities are much smaller than the long-run EM elasticity.

The empirical model fits well and provides support for the hypothesis that Canadian stock prices are more influenced by movements in emerging market stock prices than movements in US stock prices or movements in other developed markets.