Designing a Long-Short Strategy for a Canadian Investor Based on U.S. and International Market Dynamics

 The post “Is It Time to Ditch International Stocks?” first appeared on Alpha Architect blog.

What the video version of this blog here.

Designing a Long-Short Strategy for a Canadian Investor Based on U.S. and International Market Dynamics

The article "Is It Time to Ditch International Stocks?" provides a strong foundation for understanding the drivers of U.S. equity outperformance relative to international developed markets over the past decade. For a Canadian investor, these insights can be leveraged to design a long-short strategy that capitalizes on valuation disparities, earnings growth trends, and currency effects. Below, we outline a strategy rooted in the article's logic and supported by additional academic and financial research.

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Core Principles of the Strategy

This long-short strategy is built around three key drivers of equity performance, as identified in the article:

1. Valuation Repricing: U.S. stocks have benefited from significant valuation expansion, while international stocks remain relatively undervalued.
2. Earnings Growth: U.S. equities have seen superior earnings growth, driven by structural advantages such as regulatory and fiscal policies and a concentration of high-performing companies.
3. Currency Effects: The strength of the U.S. dollar has been a headwind for international investments, but potential mean reversion in the dollar could provide a tailwind for non-U.S. assets.

For a Canadian investor, currency considerations are particularly important, as the Canadian dollar (CAD) introduces an additional layer of complexity when investing in U.S. and international markets.

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Strategy Overview

The proposed long-short strategy involves:

• Long Positions: International developed markets (e.g., Europe, Japan) that are undervalued relative to historical norms and may benefit from a weakening U.S. dollar.
• Short Positions: Overvalued U.S. equities, particularly those in sectors with stretched valuations or limited earnings growth potential.
• Currency Overlay: A focus on managing CAD exposure to minimize currency risks and enhance returns.

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Step 1: Identifying Long Opportunities in International Markets

Valuation Opportunities

• As the article highlights, U.S. stocks have significantly outperformed international markets due to valuation expansion. According to AQR’s research (Asness, Ilmanen, and Villalon, 2023), about three-quarters of U.S. outperformance since 1990 can be attributed to richer valuations.
• International markets, particularly Europe and Japan, currently trade at lower price-to-earnings (P/E) and price-to-book (P/B) ratios compared to the U.S. This suggests potential for mean reversion in valuations.

Earnings Growth Potential

• While U.S. earnings growth has outpaced international markets in recent years, international earnings may rebound as global economic conditions stabilize. For example, Japan's recent shift away from negative interest rate policies could support corporate profitability (Bank of Japan Monetary Policy Report, 2024).
• European markets, which have been weighed down by geopolitical risks and slower growth, may also see a recovery as inflation moderates and fiscal policies become more supportive (OECD Economic Outlook, 2025).

Currency Tailwinds

• The strength of the U.S. dollar has been a major headwind for international investments, but as the article notes, changes in interest rate differentials could lead to a weakening dollar.
• For Canadian investors, a weaker USD relative to CAD would amplify returns on U.S. short positions while potentially boosting the value of international holdings.

Implementation

• Long International ETFs: Use ETFs such as the iShares MSCI EAFE ETF (EFA) or region-specific ETFs like the iShares MSCI Europe ETF (IEUR) and iShares MSCI Japan ETF (EWJ).
• Sector Focus: Favor sectors with strong fundamentals and attractive valuations, such as European industrials or Japanese consumer goods.

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Step 2: Identifying Short Opportunities in U.S. Markets

Valuation Concerns

• U.S. equities, particularly in sectors like technology, have seen significant multiple expansion over the past decade. The Shiller CAPE ratio for the U.S. is currently near historical highs, suggesting limited upside potential (Shiller, 2025).
• Shorting overvalued sectors or individual stocks with stretched valuations can capitalize on potential mean reversion.

Earnings Growth Risks

• While U.S. earnings growth has been strong, much of it has been concentrated in a handful of mega-cap companies (e.g., FAANG stocks). These companies face increasing regulatory scrutiny and slowing growth rates, making them vulnerable to valuation corrections.
• Additionally, higher interest rates and tighter monetary policy could weigh on corporate profitability across the board.

Currency Considerations

• A weakening U.S. dollar could reduce the purchasing power of U.S. consumers and negatively impact multinational corporations with significant overseas revenue.

Implementation

• Short U.S. ETFs: Use inverse ETFs like ProShares Short S&P 500 (SH) to gain short exposure to the broader U.S. market.
• Sector Focus: Target overvalued sectors such as technology and consumer discretionary. Alternatively, short specific stocks with high P/E ratios and slowing earnings growth.

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Step 3: Managing Currency Risk

Hedging CAD Exposure

• For Canadian investors, currency fluctuations between CAD, USD, and other currencies (e.g., EUR, JPY) can significantly impact returns.
• To minimize currency risk, consider using currency-hedged ETFs or implementing direct currency hedges through forex futures or options.

Taking Advantage of USD Weakness

• A weakening U.S. dollar could amplify returns on international long positions. However, it may also reduce the effectiveness of U.S. short positions if not properly hedged.

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Step 4: Risk Management and Diversification

Position Sizing

• Allocate a portion of the portfolio to the long-short strategy (e.g., 20-30%) to balance risk and maintain exposure to other asset classes.
• Use stop-loss orders or options to limit downside risk on both long and short positions.

Diversification

• Ensure the portfolio is diversified across regions, sectors, and asset classes to reduce concentration risk.

Monitoring and Rebalancing

• Regularly review the portfolio to ensure it aligns with the strategy’s objectives and adjust positions as market conditions evolve.

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Example Portfolio Allocation

Position	Allocation	Rationale
Long MSCI EAFE ETF (EFA)	15%	Broad exposure to undervalued international markets.
Long MSCI Japan ETF (EWJ)	10%	Benefit from Japan’s policy shift and potential earnings growth.
Short S&P 500 ETF (SH)	15%	Hedge against overvalued U.S. equities.
Short Nasdaq-100 ETF (PSQ)	10%	Target overvalued U.S. technology stocks.
Currency Hedge (CAD/USD)	5%	Protect against CAD/USD fluctuations.
Cash	45%	Maintain flexibility and liquidity for rebalancing.

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Expected Outcomes

This long-short strategy aims to:

1. Capitalize on valuation mean reversion by going long undervalued international markets and short overvalued U.S. equities.
2. Benefit from potential USD weakness, which could boost international returns and amplify gains on U.S. short positions.
3. Provide diversification and downside protection for a Canadian investor’s portfolio.

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Conclusion

For Canadian investors, a long-short strategy based on the dynamics outlined in the article offers a compelling way to navigate current market conditions. By combining long positions in undervalued international markets with short positions in overvalued U.S. equities, this approach seeks to profit from valuation disparities, earnings growth trends, and currency movements. While no strategy is without risks, this evidence-based approach provides a thoughtful framework for managing uncertainty and pursuing long-term returns.

As always, investors should conduct thorough due diligence and consult with a financial advisor before implementing any investment strategy.