Don't count on loonie to keep our stocks among front-runners

These days, there's almost universal agreement that Canada's equity markets will continue to do well relative to the rest of the world - this in an industry where unanimity of opinion on anything is always a warning sign.

There's no question that Canadian stocks outperformed in the last decade. Here's a look at what $1,000 invested at the beginning of 2000 in various markets was worth 10 years later, at the end of 2009 (for comparison purposes, all in U.S. dollars):

Toronto consulting firm Investor Economics reports that in 2009, Canadians put $26-billion into Canadian equity funds. In comparison, they put less than $18-billion into stock funds invested outside Canada.

On a net basis - the difference between money going into mutual funds compared with money taken out - foreign equity funds had a negative number with more than $5-billion withdrawn, while Canadian equity funds had positive flows of about $860-million.

Before rushing to put the bulk of your savings into Canadian stocks, however, there are some important reasons to reflect on whether investors in Canada will be rewarded in the next 10 years as they were in the past 10.

Same returns, more volatility Despite our strong performance in the past 10 years, going back to the mid-1950s the return on Canadian stocks has been slightly behind that of the United States.

Ten years ago the U.S. market had left ours in the dust: The past decade merely brought the Canada's long-term numbers close to the United States.

Making matters worse, because of our dependence on resources those results were delivered with greater volatility. Look back over time and the message is very clear: When commodity prices are strong, Canadian stock markets do well; when commodity prices are weak they underperform.

Prospects for resources Today, more than 70 per cent of the Canadian stock market's value is in two sectors, financials and resources. In essence, investing in Canada is a bet on resource prices.

While some forecast increases in resource prices, there's reason for caution, even in the face of burgeoning demand from China and India.

Years ago, I saw a chart that plotted commodity prices back over several centuries; it showed the price of commodities declining after inflation was taken into account.

The recent experience with natural gas should be a cautionary note; new technologies have allowed producers to tap into massive amounts of gas that were previously inaccessible, dramatically depressing gas prices as a result.

Impact of currency As resource prices did well over the past 10 years, the Canadian dollar went up as a result. Our dollar is sometimes referred to as a "petrocurrency," with its level tied to commodity prices. The strong dollar over the past decade contributed to the Canadian market's outperformance compared with unhedged foreign investments. That followed a long period when a weak dollar boosted the performance of foreign stocks. Over 40 years, the dollar's effect on our international stock market performance has essentially been neutral. We shouldn't count on currency to continue to give performance a lift. If resource prices decline, the Canadian dollar will almost certainly go down as well. This could lead to a double whammy on stock market levels, as a drop in resource prices would be compounded by a weaker dollar.

Rear-view mirror approach to investing Ten years ago, Canada's stock market was coming off a decade of subpar performance compared with the rest of the world. As a result, Investor Economics' tracking of mutual funds sales shows that in 1999 Canadians put $20-billion more into mutual funds invested in foreign markets than they took out - just as foreign markets were set to underperform.

By comparison, on the eve of our decade of outperformance, Canadians took almost $9-billion out of Canadian mutual funds.

This is why some academics refer to investor behaviour as a "contrary indicator" - we get into and out of investments at precisely the wrong times, buying after stock have done well and are about to take a dip, selling after they have done poorly and are about to rebound. Industry insiders often talk about four words that, through history, have proved by far to be the costliest for investors. The words? "This time it's different."

Investors ignore these words at their peril. It's theoretically possible that this time will, in fact, be different, and that Canadian stock markets will continue to outperform. But Canadian investors should understand the risks they're taking and the extent to which they're fighting the lessons of history if they overweight Canadian stocks in their portfolios.

Dan Richards is president of Clientinsights. He is a faculty member in the MBA program at the Rotman School at the University of Toronto.

dan@clientinsights.ca