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