Last year, Canada had one of the top-performing stock markets in the world.

Perhaps earnings are catching up with valuations because so far this year the benchmark S&P/TSX Composite Index is up just 1.7% on a price basis in Canadian dollar terms. Adjusted for U.S. dollars, that scant return is in the red by nearly 0.2%.

Source: Bloomberg

The Canadian market currently trades at 21.4 times earnings, a premium to its long-term average of 18.5 times.

Aside from valuation, Canadian equity markets may also be grappling with the continuing recovery from the energy crash along with new worries about the country’s housing bubble.

Nevertheless, analysts forecast Canadian equities will grow earnings per share by 26.7% for the full fiscal year, on sales growth of 6.6%. Given that the energy sector comprises more than a fifth of the broad-market benchmark, it looks like the rebound in oil prices is expected to be a major driver of earnings growth.

As the financial sector frets about systemic risk from so-called alternative lenders (more on that in this issue’s Canadian Currents), the Canadian dollar has slid toward a trailing-year low, at around US$0.73.

But the chart below also suggests that the loonie continues to be highly correlated with oil prices, based on how the currency has traded relative to North American benchmark West Texas Intermediate crude oil.

Source: Bloomberg

Meanwhile, the Canadian economy is projected to expand by 2.3% this year, which would be a noteworthy acceleration from last year. That’s also just shy of the 2.5% threshold that the Bank of Canada has previously identified as the minimum level of activity necessary to remove excess slack from the economy.

Despite relatively optimistic forecasts on both the earnings and economic fronts, we see growing downside risks to these projections. Fortunately, our favorite stocks are positioned to maintain their dividends in just about any environment.