The following was excerpted from Third Eye Capital Management Inc.'s Q1 2013 Investor Letter.

CAPE Fear

Our belief that the U.S. economy will outperform Canada's through 2013 and into 2014 is playing out in the stock market. The S&P TSX Index has lagged the S&P500 by over 15% since the beginning of the year, mostly due to weakness in commodity sector equities, which account for about 40% of Canadian stock market capitalization. Economic data in Canada has come in below expectations. The Bank of Canada is turning more cautious on the prognosis for economic growth and inflation, while housing and consumer spending remain stretched. With most commodity markets still correcting, the broad outlook for Canadian equities is not promising.

In the U.S., there is no consensus among equity investors over the recent rally in the S&P 500. Even though equities have more than doubled since March 2009, investors still withdrew $200 Billion out of U.S. domestic mutual funds and exchange traded funds between 2010 and 2012. According to research and consulting firm Hennessee Group, so-called "smart money" hedge funds remain mostly short or hedged due to "historically low VIX and unresolved structural issues in the economy". 

One equity valuation measure widely followed by hedge funds is Yale professor Robert Shiller's cyclically adjusted price-to-earnings ratio ("CAPE"), which uses the inflation-adjusted price level of the S&P 500 Index over the trailing 10-year average of S&P500 reported earnings (also inflation-adjusted). The use of the 10-year average earnings is to smooth out business cycle effects. Shiller's version of the P/E ratio correctly predicted overvalued markets in 1929, 1999, and 2008. The CAPE is currently above 23 compared to a median level of about 16 since 1880, suggesting that the stock market is poised for a substantial correction.

The problem with CAPE is that earnings smoothing can underestimate average earnings during an expansion and overestimate average earnings during a contraction, especially when you consider that the current trailing 10-year average is a historical aberration because it includes two of the worst profit recessions ever recorded: in the aftermath of the dot-com bust from 2000 through 2003, and as a result of the financial crisis in 2008 and 2009. Recessions of the past decade forced companies to shrink their balance sheets through write-offs of non-performing assets, which negatively affected profitability. Averaging in these earnings distorts the valuation picture.

S&P 500 earnings have grown 100% since their nadir in 2009, further emboldening hedge funds' current anti-equity bias.  However, the earnings yield is roughly 7.5% compared with 1.6% for Treasury yields, and such a sizable equity risk premium should continue to support stock prices in the U.S. The relative stability of data and forecasts, improving U.S. household finances, fading political uncertainty, and simulative monetary conditions are keeping both volatility and downside risks low. Companies are still deleveraging and earnings momentum is not credit driven like in previous cycles.  Meanwhile, policymakers are curtailing deflationary tail risks, which is helping investor confidence. Central banks have made an open-ended commitment to reflation, making higher prices for risk assets an objective not a by-product. U.S. equity prices should continue their rise in this environment, and the smart money may need to throw away the CAPE in order to fly.

 

Third Eye Capital Management Inc.