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Earlier this month, the Dow Jones Industrial average touched record highs, propelled by strong U.S. job-creation figures. That’s great news for investors whose portfolios contain plenty of U.S. equities. North of the border, however, the reality is that the average Canadian investor’s portfolio contains—well, mostly Canadian stocks.

In failing to diversify beyond Canadian equities, investors could be missing out on key opportunities to enhance returns and reduce risk in their portfolios. With roughly three quarters of the Canadian equity market made up of energy, materials and financial companies, it is important that Canadian investors cast their gaze beyond their own borders. Looking immediately south is often a great place to begin.

After a strong start to the year, the S&P 500 reached new highs in March, finishing the month above the previous record set in October 2007. The impressive results for the U.S. market are a continuation of a very strong period for the S&P 500. In fact, the U.S. has been one of the world’s best performers since markets bottomed in March 2009, posting a return of 14.6 per cent annually over the past four years.

One of the big questions facing investors is whether the U.S.’s current economic backdrop justifies the American market’s record high levels. Corporate results would suggest so: despite its dramatic increase, the U.S. equity market continues to be supported by improving corporate profits. Over the course of 2012, U.S. corporations delivered adjusted profits of close to $2 trillion. This level of profitability is close to a seven-per-cent increase from 2011 and up over 20 per cent from pre-recession levels. These trends look likely to continue in 2013 as overall profit margins have been helped by the slow pace of wage gains. Margins have also been helped by the low level of interest rates as companies have taken steps to refinance and issue corporate debt at record low yields, reducing their interest expenses.

A U.S. manufacturing renaissance, focused on energy, has also helped corporate profits grow. Technological advancements in oil extraction have permanently altered the global energy landscape. Currently the U.S. imports around 20 per cent of its energy needs. According to the International Energy Agency’s World Energy Outlook 2012, the U.S. will surpass Saudi Arabia's oil production by 2017 and will become a net oil exporter by approximately 2030. The abundant supply of cheap shale natural gas is also putting the U.S. on track to be a net exporter of liquefied natural gas by 2020, and making North America incredibly competitive in industries that are heavily electricity dependent or rely on natural gas as a production input.

Given its recent strength, it’s worth keeping a close eye on the U.S. equity market relative to its historical valuations. Our current view is that the market, while not the incredible bargain it was in 2009, is not expensive. The S&P 500’s current price-to-earnings ratio of 14.7 times, which measures the value placed by investors on each dollar of earnings generated by the companies underlying the index, is still priced below its long-term historical average of between 15 to 16 times.
While the price-to-earnings ratio of the index gives a general sense of the overall valuation of the market, a better indication of expected future returns is the fundamental analysis we conduct on the companies we invest in. When we look at the underlying businesses held in our U.S. equity portfolio, we are optimistic about their future earnings prospects. And it’s a healthy complement to Canadian equities, giving investors more diversity that should benefit them over the long term.

 
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Michael Job, CFA, works in the private client area at Leith Wheeler Investment Counsel. He is responsible for providing investment management services to private clients and not-for-profit organizations. This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.