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Canada has found itself in a relatively favorable economic position in the post-recession environment. The country is on a solid fiscal footing, has a low debt level, and its primary trading partner—the U.S. is back on track.

This has allowed the country to avoid the a European infection of its economic growth story, helping Canada to bounce back relatively well from the crisis. It also hasn’t hurt that the country’s banks were much more conservative, so there was much less of a hole to dig out of to begin with anyway.

Despite this, the country’s stock markets have underperformed their American counterparts, at least from an ETF look in YTD terms. The country’s most popular ETF, the iShares MSCI Canada Index Fund (EWC - ETF report) has added just under 4.4% so far in 2012 compared to a nearly 15.8% gain for the S&P 500 in the same time period  (read Generate Alpha with these Outperforming ETFs).

This is somewhat surprising, as for the most part, EWC and SPY have an extremely high correlation with each other, pretty much moving in lockstep. Seemingly the only difference—besides the divergent returns—has been a greater volatility level for EWC.

Admittedly, this is a disappointing result for the Canada ETF as the country should have been a big beneficiary of the rebounding American economy. Plus, a floor under many commodity prices could have also been a catalyst for strength in the Canadian stock market this year.

While this was certainly not the case in the beginning of the year, it appears as though these factors are finally trickling down into stock prices as we close out 2012. In fact, over the past six months the highly correlated SPY and EWC are now showing that EWC is the better performer, edging out its American counterpart by several percentage points in the time frame in question (see The Five Best ETFs over the Past Five Years).

This could suggest that the sentiment is finally starting to turn on the overlooked Canadian market, and that now might be the time to consider a play on America’s neighbor to the north in ETF form, as EWC currently receives a Top Zacks ETF Rank of 1 or ‘Strong Buy’. This could be particularly true if two vital sectors for the Canadian stock market continue to hold up; financials and commodities.

Although the Canadian economy is pretty well diversified, EWC and the broader Canadian stock market are relatively concentrated in a few key sectors. Financials (32%), energy (26%), and basic materials (19%), account for the lion’s share of assets in EWC, leaving a paltry amount for the rest.

Furthermore, among the top ten individual securities, financials take up four of the top five spots, while only one company outside of the three sectors listed above makes its way into the top ten. This is despite the fact that the ETF holds over 100 securities, showcasing just how concentrated in these few segments this ETF is (Canada Equity ETFs Worth a Look).

As a result, these sectors look to play an outsized role in Canada’s stock recovery heading into 2013. There is somewhat of a high bar for this as well, as the yield is pretty much the same for this fund as the S&P 500, although EWC costs 52 basis points a year, a far greater level than what ultra-low cost S&P 500 ETFs charge investors currently.

With this price differential and high correlation to the American market, it could be tough to outperform but not impossible. A few things will definitely have to happen though for EWC to continue its winning streak against SPY:

First, commodity prices must remain stable, or even better, rise. Oil is a key product for the country and thanks to fracking technologies, could be even more so as the years go by (see Top Commodity ETFs in This Uncertain Market).

Beyond oil, the country is also a big producer of agricultural commodities as well, so these will have to stay strong heading into 2013. Base and industrial metals are also key, and these can be volatile so it could be a rocky road in this corner.

Either way, it is hard to imagine continued outperformance without another strong showing from the Canadian financial sector. As we touched upon earlier, the space has done better than most, but some concerns are starting to appear (read Active Large Cap ETFs: The Best of Both Worlds?).

Worries over a property bubble are spreading in some parts of the country, which could be damaging to bank credibility across the nation. In particular, prices are being bid up in Vancouver on strong Asian demand while a similar situation is happening in Toronto.

Resource-oriented cities could also be experiencing a bit of a boom, while some of the recent housing data hasn’t exactly been favorable. Should a bubble burst in Canada, the financial sector could be taken for a ride and end the short-term outperformance of Canada against the U.S.

Our view is that Canada has not overheated and that its robust financial position overall, combined with its in-demand commodities, will power it through in the short term. While there are definitely some pressing issues in regard to the housing mess, we think that Canada could be an interesting relatively short-term play for investors seeking to make an equity play as we close out the year and head into 2013.

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