Fund Performance Commentary

Fund Performance Commentary // November 2019

By November 30, 2019 March 3rd, 2020 No Comments

Have we learned nothing from the past?


Financial pundits have begun to discuss the possibility that perhaps due to low rates, and with rates unlikely to rise anytime soon, financial markets may have reached a “permanently high plateau” supported by near zero percent rates globally.

This should, however, cause market participants unease as this phrase has been used before, most notably by Professor Irving Fisher in 1929 immediately prior to equity markets losing roughly 90% of their value over the following years.  He opined that corporate profits seemed to support the rise in share prices over the previous decade and therefore the level of equity prices was justified and likely to stay elevated.

Stock prices have reached what looks like a permanently high plateau.
– Professor Irving Fisher, October 15, 1929

And he was not the only academic and/or market prognosticator saying similar things right at the peak of the market.  For markets to reach such elevated valuation levels, as in 1929 (and today), there must be a choir pushing a narrative that is accepted by the masses.

At Q3 2019, the value of all S&P 500 companies trades at 2.17 times their combined revenue. This represents a willingness among investors to overpay for assets like no other time in history. Market value relative to revenue (or sales) allows us to view current prices relative to historical prices of assets. As noted, the S&P 500 has never been so expensive relative to the amount of sales being generated. Add to that the fact that earnings growth in the last quarter was negative and one might be perplexed why equity values continue to levitate near all-time highs.

Meanwhile, GDP YoY growth in the US has migrated downward from about 4% earlier in this expansion down to 1.9% this year, with the final quarter of 2019 looking like 0% or possibly even a negative print (recall that a recession is typically defined as two consecutive contractions in quarterly GDP). Residential construction has contracted for 6 of the last 7 quarters.  Commercial real estate has been contracting for majority of the past 5 quarters. Exports are down 5 of the past 6 months. Capital spending is in recession and if businesses are not investing in themselves it will be difficult to grow in the coming quarters and years. Equity markets typically require companies to be growing at positive rates to justify their valuations – and that is especially true with valuations at today’s obscene levels.

This is not what a bull market looks like.  Equities however have not received that memo.

Markets were higher in November.  A significant portion of our losses in the month came from idiosyncratic risk; several positions moved independent of the market.  A number of the companies we are short posted what were interpreted as good results and the market reacted disproportionately rewarding those companies handsomely. We are in a phase of the cycle characterized by euphoria. We believe that Home Capital Group in Canada remains at high risk during the next downturn. Since Q1 2018, they have grown their residential non-securitized  mortgages in British Columbia by $437 million (+74%) and in Ontario by $473 million (+5.4%). The major banks have begun to tighten their lending standards pushing borrowers to  lenders. Home Capital is “benefiting” from the larger banks becoming more prudent and they are happy to accept the risk of underwriting the mortgages that the banks will not.  Of course, when a bank originates a mortgage irrespective of how the loan works out, they immediately book themselves a profit for underwriting the deal. This is a little like making a loan to a friend that you know is not credit worthy and then rewarding yourself with a profit on paper even though it is unlikely that you will get your money back.  At what appears to the be top of a housing cycle, Home Capital’s stock moved higher on the news that they generated significant “profits” originating risky mortgage loans.  As one person commented on the news “have we learned nothing from the past?”.

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