As the S&P/TSX composite index has eliminated its historical valuation gap to the S&P 500, a new report from UBS Securities Canada question whether this parity is sustainable.

“The 6% rise in the TSX in January on top of its big gain in 2005 has brought forward issues about its valuation. At this point, the TSX has completely eliminated its historical discount from the S&P 500, with both trading at about 15x 2006 earnings,” it says. “The question now is whether or not the TSX should trade at par to the S&P 500.”

The report concludes that the answer depends on your view of energy prices. “Valuations are clearly higher in energy, however, and make sense if investors are discounting oil prices higher than UBS’s long-term assumption of US$43,” it notes.

Since 1987 the average TSX multiple has been 1.2 points below that of the S&P. “And though the respective market P/Es are now the same, that doesn’t allow for the fact that the TSX’s multiple is held down because its two biggest sectors are low P/E. Indeed, if the TSX had the same P/Es as the S&P 500 for all 10 sectors, its ‘market’ multiple would be 13.1x — in other words our valuation is 1.9 points higher, not the same,” it says.

“The higher valuations are confirmed sectorally, with six of the TSX P/Es higher than that for the S&P, two about the same, and only two that are notably less,” it says. “The question is whether the premiums are warranted.”

“One of the most obvious changes that would raise TSX valuations has been the elimination of its historical ROE discount compared to the S&P 500, which we believe could actually eke ahead in 2006. In addition, bond spreads that had been typically 100-200 bps higher than in the U.S. tended to depress our P/Es,” it notes. These negative spreads are poised to stay because of Canada’s lower inflation track, and current account and fiscal surpluses, UBS says.

The P/Es on the three largest TSX sectors – energy, materials and financials – are 1.8 to 2.9 points higher, it notes. In the materials group, the TSX’s higher valuations, “reflect compositional differences between the two sectors—about one-third of the TSX index is golds, while one quarter of the S&P is two large chemical companies that trade at an average of 11x earnings.”

In the banks group, UBS, “believes that the higher TSX multiples reflect their excess capital, which has not been there in the past. Adjusting for this, and recognizing our lower bond yields and recent dividend enhancements, explains the gap, in our view, but it is therefore likely to persist.”

“We expect relatively higher ROE’s and negative bond spreads to continue in the medium term, with higher headline valuations in the banks and larger gold weighting adding arithmetic support from within the index. The key factor in the convergence of the “market” multiple is now energy, given both its 29% weight in the TSX and higher head-to-head valuations. For those with a bullish long term stance on energy prices, these valuations may be warranted,” it concludes.