Latest / How Canadian Markets Work / Episode 60: Why Canada Looks Like Canada (The Diversification Delusion)

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Episode 60: Why Canada Looks Like Canada (The Diversification Delusion) · How Canadian Markets Work

0:00
Try this sort of two second test. If you were
0:03
to ask someone to name the sectors dominating
0:05
the US stock market, they'd probably list technology,
0:09
healthcare, maybe consumer discretionary. Oh,
0:11
financials, industrials, sure. They could keep
0:13
going for a while. Right. They could comfortably
0:15
keep going. You're visualizing this massive,
0:18
highly diversified economic engine. But if you
0:21
ask that exact same person to name the sectors
0:25
dominating the Canadian market, I mean, it's...
0:29
banks, oil and gas, mining. Yeah, that takes
0:33
exactly two seconds. Literally two seconds. The
0:35
entire Canadian market is describable in one
0:38
single incredibly brief breath. It's such a striking
0:42
contrast, and honestly, it establishes the core
0:45
focus of our deep dive today. We've been looking
0:47
through this massive stack of sources detailing
0:50
the structural history of Canadian markets, current
0:52
sector weighting, some really advanced portfolio
0:55
management concepts, all to unravel this very
0:57
specific puzzle. Yeah, a puzzle that affects
0:59
almost everyone listening. Exactly. Because buying
1:02
a broad Canadian index fund is constantly pitched
1:05
to you, the investor, as the ultimate way to
1:08
achieve true diversification. But the reality,
1:11
the reality hidden in the data, is that a domestic
1:13
index fund is actually just a diversified holding
1:16
within an incredibly concentrated market. And
1:19
that distinction, I mean, that changes everything
1:21
about how you build a personal financial plan.
1:23
Yeah. So we know what the Canadian market looks
1:26
like, right? We just said it. It's overwhelmingly
1:28
weighted toward financials. energy and materials.
1:31
Right. The big three. The big three. But rather
1:34
than just, you know, accepting that as a quirk
1:36
of geography, our mission today is to understand
1:39
the actual mechanics behind it. Because this
1:41
concentration is not some historical accident.
1:44
It's it's a structural inevitability. And our
1:47
sources point to four distinct forces driving
1:49
this. Yeah. And I think we should just jump right
1:51
into the first one, which is the resource endowment
1:53
itself. I mean, Canada is physically massive.
1:56
And beneath all that landmass, you have enormous
1:59
quantities of oil, natural gas, potash, uranium,
2:03
gold, timber. But knowing the resources are there
2:06
and actually getting them to market, those are
2:08
two entirely different universes. Right. The
2:10
gap between those two things is huge. It is.
2:13
Because extracting these materials is just uniquely
2:15
capital intensive. Well, I want to slow down
2:18
there and really look at the mechanics of that.
2:20
Because it explains why these companies take
2:22
up so much oxygen in the stock market. If you
2:24
want to start, say, a software company, you might
2:27
need a laptop, a small team, maybe some venture
2:29
capital. A pretty lean operation, usually. Exactly.
2:32
But if you want to build a copper mine in the
2:35
Canadian Shield or an oil sands extraction facility
2:38
up in northern Alberta, you're talking about
2:41
spending, I mean, billions of dollars over a
2:44
decade before you ever produced a single ounce
2:47
of metal or barrel of oil to actually sell. And
2:50
that massive capital requirement completely dictates
2:54
how these businesses have to be structured. You
2:57
can't simply walk into a local bank and ask for
3:00
a $10 billion commercial loan to dig a hole in
3:03
the ground that, quite frankly, might not yield
3:06
anything for 10 years. Yeah, the bank would laugh
3:08
you out of the room. Right. The risk is just
3:11
way too high for traditional debt financing at
3:13
that early stage. Therefore, these companies
3:16
are forced to issue public equity. They have
3:18
to raise massive amounts of money directly from
3:21
the public markets by selling shares. So just
3:24
because the physical act of extraction requires
3:26
immense upfront capital. These resource companies
3:30
naturally balloon in size on the stock exchange.
3:32
Yep. Mechanically speaking, they issue so much
3:34
equity just to exist, just to survive the early
3:37
phases that they take up a disproportionate percentage
3:40
of the domestic market capitalization. That's
3:43
the baseline. The physical geography dictates
3:45
the capital structure, which in turn dictates
3:48
the shape of the stock index itself, which flows
3:50
right into the second driver from our sources,
3:52
which is the banking structure. So to fund an
3:55
economy of this massive scale, Canada developed
3:58
a very small number of really large national
4:02
banks, rather than thousands of localized regional
4:06
banks like you see down in the United States.
4:08
And this was driven by deliberate historical
4:10
policy. Oh, absolutely. The government wanted
4:12
to avoid the constant regional bank failures
4:15
that were, you know, plaguing other countries.
4:18
So they fostered this heavily regulated environment
4:21
that really favored a few dominant players with
4:23
nationwide reach. But I actually want to push
4:26
back on how this is usually framed in the financial
4:28
media. Oh, really? How so? Well, people constantly
4:31
praise the Canadian banking oligopoly for surviving
4:34
the 2008 financial crisis so well. You know,
4:37
we always hear about the legendary stability
4:39
of the Canadian banking system. Sure. Yeah, it's
4:41
a huge point of pride. Right. But when those
4:44
exact same analysts look at a Canadian index
4:46
fund, they complain endlessly about the dangerous
4:49
concentration of the financial sector. Oh, I
4:52
see where you're going with this. Yeah. The reality
4:54
is The legendary stability of our banks and the
4:57
dangerous concentration of our stock index. They're
4:59
the exact same phenomenon. It's literally just
5:02
wearing a different hat, depending on who is
5:04
complaining at the time. That is a brilliant
5:06
way to frame it. And the underlying mechanism
5:08
proves your point perfectly. I mean, the concentration
5:11
that allows those four or five banks to achieve
5:14
massive economies of scale, absorb those regional
5:17
shocks, and maintain regulatory stability, that's
5:20
the exact same concentration that makes your
5:22
domestic index fund so incredibly top heavy.
5:25
It's a stublet sword. Always. Structural features
5:28
always cut both ways. You simply cannot have
5:31
a highly consolidated, unshakable banking sector
5:34
without that sector absolutely dominating the
5:36
stock exchange it trades on. Yeah, that makes
5:38
complete sense. It makes sense that resources
5:40
and banks take up so much room. But, you know,
5:43
surely there are other industries trying to break
5:45
through. Like, what happens to the technology
5:47
or healthcare companies that should, in theory
5:49
anyway, balance out this index over time? Well,
5:52
they encountered the third structural driver,
5:54
which is the small domestic market. This is basically
5:57
the gravity that high -growth Canadian companies
6:00
simply cannot escape. How does that play out
6:02
in practice? Imagine a Canadian software company,
6:05
right? They create a phenomenal product, they
6:08
conquer the entire domestic market, they reach
6:10
a billion -dollar valuation, and now they need
6:13
to scale globally. The pool of investment capital
6:16
in Canada is simply not deep enough to fund that
6:20
next massive phase of global expansion. Right,
6:22
they hit a ceiling. So their natural next step
6:25
is to look south. They need to tap into the massive
6:28
liquidity of the U .S. Exactly. And when they
6:30
expand south, the mechanics of the market actually
6:32
pull them away. successful Canadian tech often
6:36
leaves the pure domestic index entirely. Oh wow.
6:39
Yeah, they might get acquired by a much larger
6:41
American tech giant or they might do a list on
6:44
a US exchange where the trading volume just completely
6:46
dwarfs their Canadian listing. So the very companies
6:49
that would naturally diversify our index, you
6:51
know the high -growth non -cyclical innovators,
6:54
they end up draining right out of it the moment
6:56
they become large enough to actually make a dent
6:59
in the sector weightings. Yep. Leaving the banks
7:01
and the resource companies right back at the
7:03
top of the pile. OK. So we have resource extraction
7:06
reliant on public equity. We have a consolidated
7:09
banking oligopoly. And we have a ceiling on growth
7:12
companies that pushes them out of the country.
7:15
Now, there is a fourth driver mentioned in our
7:17
sources, restricted sectors. But I have to admit,
7:20
I get a bit lost on how this one actually inflates
7:23
market cap. Help me understand how limiting foreign
7:26
ownership artificially shapes the size of domestic
7:29
companies. It really comes down to artificial
7:31
protection. In certain industries deemed essential
7:34
to national infrastructure, so most notably telecommunications
7:38
and airlines, the government places strict historical
7:40
limits on how much of a company can be owned
7:43
by foreign entities. So a massive American telecom
7:46
giant cannot simply come in and out right by
7:49
a major Canadian telecom provider. Correct. It's
7:51
legally protected from international takeover.
7:54
But think about the unintended consequence of
7:56
that protection. OK. Because these domestic telcos
7:59
face zero threat of being swallowed by global
8:01
competitors and because the barriers to entry
8:04
for a new domestic competitor are just absurdly
8:06
high, the existing players consolidate. They
8:09
buy up all the smaller regional players. I see.
8:12
Yeah. They become massive fish in a heavily protected
8:15
medium sized pond. They generate enormous stable
8:18
cash flows, which they pay out as dividends,
8:21
which in turn makes them highly attractive to
8:23
investors, which further drives up their market
8:25
capitalization. Ah, so it just feeds itself.
8:28
So we have this highly specific macro environment,
8:31
but I want to pivot this entire conversation
8:34
down to the listener's actual brokerage account,
8:36
because if you're listening to this, you are
8:38
probably holding a portfolio that you genuinely
8:41
believe is carefully balanced. How does this
8:44
structural concentration silently hijack your
8:47
supposedly diversified retirement plan? It hijacks
8:50
your portfolio through hidden correlations. We
8:54
just establish financials, energy, and materials
8:57
as the dominant sectors. And if you look at them
8:59
purely by their labels on a computer screen,
9:01
they seem like three completely different uncorrelated
9:04
industries. Right. A bank teller doesn't drill
9:06
for oil. Exactly. And an oil rig worker doesn't
9:10
underwrite mortgages. But economically speaking,
9:13
they are deeply and structurally linked. Let's
9:16
trace that linkage for a second. Energy and materials
9:19
both move in lockstep with global commodity demand.
9:23
Right. So if global industrial activity slows
9:25
down, say, you know, manufacturing in Asia cools
9:28
off the demand for both crude oil and industrial
9:30
metals like copper drops, those two sectors weaken
9:33
together. They're cyclical twins. But how does
9:36
the banking sector get dragged into that exact
9:38
same cycle? Through regional economic exposure,
9:42
Canadian banks do not operate in a vacuum. They
9:44
lend heavily into the domestic economy. They
9:46
hold the mortgages for the families working in
9:48
those resource -heavy regions. They provide the
9:51
commercial loans to the local businesses that
9:53
service the mining and energy sectors. So if
9:56
global commodity prices drop, the regional economies
9:59
in Canada that rely on those commodities immediately
10:01
weaken. Projects get cancelled. People lose their
10:04
jobs. And when people lose their jobs, they can't
10:06
pay their mortgages. local businesses slow down
10:09
and default on their commercial loans, that ripple
10:11
effect instantly hits the bank's credit quality.
10:15
Their loan loss provisions have to go up and
10:17
their stock prices go down. The underlying mechanism
10:20
here is just so important to grasp. The banks
10:23
are exposed to the exact same commodity cycle
10:25
as the drillers and the miners. They're just
10:28
one step removed. The correlation is delayed,
10:30
but it is absolute. Yes. And the linkage goes
10:33
even deeper when you look at interest rates.
10:35
The resource sector, as we discussed, is intensely
10:38
capital heavy, which means they carry massive
10:41
debt loads to fund their operations. Right. So
10:43
when interest rates rise, their debt servicing
10:45
costs explode, which eats into their profits.
10:48
Simultaneously, banks are highly sensitive to
10:51
interest rates through their net interest margins.
10:53
So the difference between what they pay out on
10:55
deposits and what they charge on loans. So a
10:58
sudden shift in monetary policy can hammer all
11:01
three of those dominant sectors simultaneously.
11:04
for slightly different mechanical reasons, but
11:07
with the exact same catastrophic result for the
11:10
overall index. This is exactly where we see investors
11:13
inadvertently building massive risk into their
11:16
accounts. The sources actually call it the five
11:19
holding illusion, and it is an incredibly common
11:22
trap. I really want to break this down because
11:24
it perfectly illustrates how insidious these
11:26
hidden correlations are. Picture this scenario,
11:29
and this probably looks a lot like your own self
11:31
-directed account. You want to be responsible,
11:33
so you buy five distinct things. Okay, let's
11:35
hear them. First, you buy shares in one of the
11:37
big Canadian national banks. Second, you buy
11:40
a major pipeline company. Third, you add a large
11:42
gold mining operation. Fourth, a major telecommunications
11:46
provider. And fifth, just to ensure you have
11:49
broad, stabilizing exposure, you buy a broad
11:51
Canadian index fund. Sounds great on paper. Right.
11:54
On paper, looking at five different ticker symbols,
11:56
you feel completely diversified and safe. But
11:59
if we run those five holdings through the correlation
12:02
mechanism we just outlined, the safety completely
12:05
vanishes. We have to count the underlying economic
12:08
exposures, not just the ticker symbols. Right.
12:10
Let's dismantle it. So your first holding, the
12:13
bank, is pure financials. Yep. Your second holding,
12:17
the Pike Lane Company, is technically categorized
12:19
as energy infrastructure, but its revenues are
12:22
entirely dependent on the volume of oil flowing
12:25
through it, which is tied to the health of the
12:27
energy producers. So holding number two is highly
12:30
correlated to the commodity cycle. And your third
12:33
holding, the gold miner. is pure materials, also
12:36
directly tied to global commodity cycles, and
12:39
like you said, interest rate movements. So right
12:41
away, three of your five holdings are basically
12:42
the same highly correlated, cyclical bet on resources
12:46
and the debt used to finance them. Exactly. What
12:49
about the telecommunications company? Well, the
12:51
telco is your only genuinely defensive outlier
12:54
in this scenario. It operates domestically, it's
12:57
legally protected from foreign competition, as
12:59
we discussed earlier, and people continue to
13:02
pay their cell phone bills even during a recession.
13:05
Its revenues don't swing wildly with the spot
13:07
price of crude oil, but the real danger lies
13:10
in that fifth holding. The so -called safe, broad
13:13
Canadian index fund. Exactly the issue. Think
13:15
about what is inside that index fund. Because
13:18
of the four structural drivers we covered, that
13:20
fund is massively overweight in financials, energy,
13:23
and materials. Oh, so by buying the index fund
13:26
to protect yourself, you're really just proportionally
13:29
reinforcing the exact same banks, pipelines,
13:33
and miners you already own individually. You
13:35
are layering concentration on top of concentration.
13:38
When a global commodity downturn hits, you do
13:40
not have five different economic engines protecting
13:42
your wealth. You essentially have one massive
13:45
cyclical engine that is stalling out and one
13:47
defensive telco trying to hold the line. Wow.
13:50
The correlation hides behind different logos
13:52
and company names, but the underlying economic
13:54
reality pulling the strings is identical. And
13:58
there is a behavioral trap here that we really
14:00
need to expose because the government actually
14:04
actively incentivizes you to make this mistake.
14:07
Our sources highlight the role of the Canadian
14:09
dividend tax credit. Yes, this is a crucial piece
14:12
of the puzzle. The government designed the dividend
14:15
tax credit to prevent double taxation. Since
14:18
the corporation already paid tax on its profits,
14:21
the individual investor gets a tax break when
14:23
they receive those profits as a dividend. But
14:25
the catch is... The tax credit only applies to
14:28
dividends paid by Canadian corporations. Right,
14:31
which heavily, artificially skews investor behavior.
14:34
If a Canadian investor is looking for yield,
14:36
the tax code makes a 5 % dividend from a domestic
14:39
bank mathematically far superior to a 5 % dividend
14:43
from, say, an American health care giant. So
14:46
investors, particularly retirees who are looking
14:48
for income, They gorge themselves on domestic
14:51
banks, telcos, and energy pipelines, completely
14:53
ignoring the massive correlation risk they are
14:55
taking on simply because they are blinded by
14:58
the tax efficiency. It creates this incredibly
15:00
dangerous feedback loop where domestic retail
15:03
investors are constantly buying the exact sectors
15:06
that are already dominating the index, further
15:09
solidifying the concentration. This raises such
15:11
an important point. about how we define our portfolios
15:15
in the first place. When you log in your brokerage
15:17
app, you see your stocks, your bonds, maybe some
15:20
cash, but you are missing the single largest,
15:24
most critical asset you own. An asset that almost
15:27
no one includes in their asset allocation, but
15:30
which honestly dictates everything. Your human
15:32
capital. Your day job. Yeah. If you are listening
15:35
to this, your ability to wake up, go to work,
15:37
and earn an income is a massive part of your
15:40
overall financial portfolio. It has a yield,
15:42
it has volatility, and most importantly, it has
15:44
a correlation to the broader economy. Absolutely.
15:47
If you work in Alberta's energy sector as an
15:49
engineer, your human capital, your paycheck relies
15:52
almost entirely on the global price of commodities.
15:55
If your investment portfolio is heavily concentrated
15:57
in Canadian equities, which we now know are heavily
16:00
chained to those same commodities, well, your
16:02
investments and your paycheck are effectively
16:04
the exact same asset. Think about it this way.
16:07
Building a portfolio like that is like. buying
16:11
a wildly expensive umbrella that has been chemically
16:14
programmed to instantly dissolve the moment it
16:17
touches rain. That's a great way to put it. The
16:19
entire purpose of your investment portfolio is
16:21
to protect you when times get hard. But by failing
16:25
to account for how your human capital correlates
16:27
to the domestic stock market, you are structurally
16:30
guaranteeing that your portfolio will crash at
16:33
the exact moment you were laid off and actually
16:35
need to sell your investments to survive. It
16:37
is a terrifying reality when you actually map
16:40
it out. And this risk is often actively compounded
16:43
by something that most people view as a fantastic
16:46
workplace benefit. Generous Employee Share Purchase
16:49
Plans, or ESPPs. Oh, this is the ultimate trap
16:52
for the corporate worker. It really is. The psychology
16:55
of an ESPP is incredibly alluring. Your employer
16:57
offers to let you buy company stock at a 10 %
16:59
or 15 % discount, or maybe they match your contributions.
17:02
It feels like free money. Who wouldn't take that?
17:04
Right. So let's say you work for one of the massive
17:08
Canadian national banks. You naturally want that
17:10
free money. So you participate heavily in the
17:13
ESPP, steadily accumulating bank shares. At the
17:16
same time, your day job, your human capital is
17:21
obviously tied to the financial sector. And then
17:23
in your separate retirement account, you hold
17:25
a broad Canadian index fund because you want
17:28
to be diversified. You are now triple leverage
17:30
to the Canadian financial sector. Exactly. Your
17:33
income, your direct stock holdings from the ESPP,
17:36
and your broadly diversified mutual fund will
17:39
all suffer simultaneously if the domestic credit
17:41
cycle turns or, say, if the housing market softens.
17:45
Now, to be clear, we are not saying you should
17:47
turn down the free money or the discounted shares
17:49
from your employer. That is a valuable part of
17:51
your compensation. No, definitely take the match.
17:53
But you have to understand the mechanical risk
17:55
it introduces. You have to deliberately and systematically
17:59
sell some of that company's stock over time.
18:01
and move it into assets that have absolutely
18:03
nothing to do with your industry. You have to
18:05
detach your savings from your paycheck. The contrast
18:08
to this scenario is just as illuminating. Think
18:11
about a civil servant, a tenured teacher, or
18:14
a registered nurse. Their human capital operates
18:17
completely differently. It acts almost like a
18:20
highly secure fixed income government bond. Their
18:24
income is incredibly stable and largely uncorrelated
18:27
with the stock market, the credit cycle or global
18:30
commodity prices. Because they have that massive
18:33
invisible bond anchoring their life, they actually
18:36
have the structural capacity to take on significantly
18:39
more equity risk in their investment portfolio
18:42
than someone of the exact same age and income
18:45
who works in a cyclical industry like construction
18:47
or mining. Because if the market crashes by 30
18:50
percent, the nurse is still going to get their
18:52
paycheck. Exactly. The teacher is still going
18:54
to work. They can afford to let their portfolio
18:56
recover because they don't have to liquidate
18:58
their holdings at the absolute bottom just to
19:00
keep the lights on. Your job is an invisible,
19:02
highly correlated asset. If you do not explicitly
19:05
account for how your paycheck correlates with
19:07
your portfolio, you are taking on a massive structural
19:11
concentration risk that was never on any standard
19:14
risk tolerance questionnaire you filled out.
19:17
This just entirely changes the lens through which
19:19
we view investing. We started by mapping out
19:22
the unique, incredibly concentrated structure
19:25
of the Canadian stock market. We proved that
19:27
it is essentially a massive bet on financials,
19:30
energy and materials, driven by deep historical
19:33
inevitabilities. right? Our resource endowment,
19:36
our banking history, the ceiling on our domestic
19:38
tech market, and our restricted sectors. And
19:40
then we trace the mechanisms of how that macro
19:43
structure creates hidden underlying correlations.
19:46
We saw how interest rates and regional economic
19:48
ties turned seemingly diversified five holding
19:51
brokerage accounts into single points of failure.
19:54
Yeah. The illusion of safety shatters when you
19:56
realize all your bets are chained to the exact
19:58
same commodity cycle. Finally, we map that invisible
20:01
market structure directly onto your real life.
20:04
proving that your career is an asset that absolutely
20:07
must dictate your investment strategy. Now, it
20:10
is important to acknowledge that some home bias
20:12
is rational. Our sources clearly note that Canadian
20:16
dividend tax credits do offer real mathematical
20:18
value, and matching a portion of your investments
20:21
to the currency you actually spend your money
20:22
in makes logical sense. Of course. But blindly
20:25
buying the domestic index, assuming it provides
20:28
a safety net through diversification, is an uncounted
20:31
systemic risk. Which leaves us with a final slightly
20:34
counterintuitive concept for you to mull over.
20:37
If we follow the logic we've laid out today,
20:39
we have firmly established that as a Canadian
20:41
investor, your job, the value of your local real
20:44
estate and your domestic index fund are all secretly
20:47
chained to the exact same cyclical rock. Right.
20:50
Therefore, achieving true financial safety might
20:52
mean doing something that feels, on a purely
20:55
gut level, incredibly risky. Which is what? What
20:58
should they do? Intentionally seeking out foreign
21:00
volatility. By buying international assets and
21:04
sectors completely alien to the Canadian economy,
21:07
say European healthcare giants or American semiconductor
21:10
technology, you introduce massive uncorrelated
21:14
volatility into your portfolio. That's a good
21:16
thing. And that is exactly the point. You ensure
21:19
that when a local domestic crisis freezes your
21:22
industry and tanks the Canadian index, you are
21:24
the one person with unaffected, thriving capital
21:27
to rely on. You essentially build an umbrella.
21:30
out of materials that are entirely immune to
21:32
Canadian rain. Taking a flyer on an international
21:35
tech fund isn't the reckless part of your portfolio.
21:38
It is the structural anchor that saves you when
21:41
the two -second sectors inevitably take a hit.
21:44
Well, thank you for joining us on this deep dive.
21:46
Take some time this week to look at your own
21:47
portfolio and your own paycheck. Through this
21:49
new diagnostic lens, see if you can spot the
21:52
hidden correlations before the rain starts. Until
21:54
next time.