The S&P 500 is at a record high and we believe the markets generally are fully valued. Corporate revenue growth is anemic, profit margins are stretched, and the prospect of earnings rising meaningfully is not high. And, the outlook for the U.S. and global economy is still uncertain. Market psychology is at a level suggesting the market is overbought. Margin debt is at record levels and the current popularity of stocks by retail investors at market highs is in itself a red flag. The equity markets have benefited from the huge inflows from low yielding bond funds into U.S. equity funds. We don’t believe that a bear market is looming, merely that a healthy, overdue correction could be near. And that, from current levels, the upside is likely to be below average, particularly because the S&P 500 is already 7% above our Fair Value estimate. The U.S. indexes are also 30% above our TRIM™ lines, as stretched as they ever get, and at TRAC™ ceilings.

As value investors, we are finding we need to turn over more rocks to find those value opportunities that meet with our risk-reward parameters. We have previously pointed out, one of the most overvalued groups is the so-called defensive consumer staples, today’s apparent proxy for bonds. Conversely, the most undervalued are the cyclicals, materials, energy and commodity stocks generally. Axiomatically, outperformers tend to be more fully valued or overvalued than underperformers. Value is usually found in what is unpopular. Benjamin Graham, the father of value investing (Herb thinks he is) said, in the short term the market behaves like a voting machine, but in the long term it acts like a weighing machine. Witness Splunk, Lifelock, Facebook and, recently, Twitter, at about 25 times projected 2014 sales—exuberant voting.

Interestingly, new share offerings soared over $15 billion in one week recently, the highest volume this year, while corporate buy-backs have slowed to the lowest since '09. And, unprofitable stocks recently represented over 60% of IPOs, the highest level since 2000. The number of bullish investment advisors compared to those bearish is over 3, another indication of excessive voting machine sentiment. Indiscriminate and overly exuberant buying means investors are skipping over the rocks, not looking under them. Shades of the 2000 bubble? Only about 15% of our 1,000 company global large-cap universe trades for less than $0.80 on the dollar according to our valuation model (TVM™). A level typical of market tops. As consummate value investors we are wary of the voting machine which makes the markets overvalued, and we are waiting patiently on the weighing machine we always embrace.

Understandably, in this market euphoria, hedge funds, hurt by their shorts, have significantly underperformed their long-only counterparts, and our hedging activities (albeit relatively small) have also hindered our performance. Many have even launched long-only versions of their hedge funds (i.e., without hedges). But, as we attempt to protect against the downside, we believe shorting will prove to be worthwhile and we will be rewarded.

Oh, Canada

The Canadian markets have significantly underperformed their U.S. counterparts. The TSX is up 10% (CAD) in the last 12 months compared to 31% (USD) for the S&P 500 and 32% for the NASDAQ. Interestingly even the U.S. small cap Russell 2000 is up about 39% over the same period. We attribute Canadian market underperformance to the fact the TSX is populated with more basic materials companies. Gold and silver stocks have been a disaster. Canadian junior companies have been in a bear market, the TSX Venture Exchange, the proxy for small cap Canada, down 22% (CAD) in the last 12 months and down 73% from its '07 high. Recently, however, it has bounced off a floor in our TRAC™ work and has started rising again.

Our Canadian small cap names have obviously suffered too, and impacted our performance, notwithstanding that our larger cap names have performed very well.

Though we want to continue to hold cheap small caps because we expect them to significantly outperform going forward, we are focussing more on undervalued larger cap names. Looking under boulders, not rocks, or should we say, pebbles. And we look internationally, not just in the U.S. or Canada. We screen some 1,000 large cap names globally, and hope by looking carefully under rocks we can start to outperform. We want to be rock stars again.

Rock Skeptics

We also want to look carefully, and skeptically, under the rocks of recent economic and market data. The S&P 500 is at a high. So too are corporate margins. Sales increases have been less than robust and costs should ultimately start rising, particularly from higher labour costs. Going forward, earnings growth may be stalled. U.S. cyclical stocks have had negative growth for three of the last five quarters. Corporate insiders are wary too, as evidenced by rising insider selling.

While the U.S. October payroll report was better than expected, the unemployment rate rose slightly to 7.3%. And the labor force participation rate dropped to its lowest since 1978, private sector hiring actually declining, and average hourly earnings rising only marginally. Although housing prices have strengthened, with rents also inflating from an undersupply of rentals, paradoxically, September and October saw a decline in pending home sales, the lowest since December, likely from the higher mortgage rates and prices. Housing starts have also been low, back to the '50s level, so there is not a lot of supply. But building permits climbed in October to the highest in 5 years, so housing should contribute to growth.

Consumer sentiment also worsened in October and November to its weakest in ten months, no doubt affected by the Federal shutdown which in turn influenced the consumer’s outlook for the economy. And many large retailers, such as the largest, Wal-Mart, are reporting disappointing earnings.

On the other hand, U.S. and Canadian manufacturing expanded in October at the fastest pace in nearly 3 years. Indeed, October was the fifth month in a row of faster manufacturing growth, which seems also to have picked up around the world, China and other Asian manufacturers showing the quickest upturn in months.

Economic Dichotomies

Despite the improved manufacturing numbers, world economic growth remains sluggish. U.S. and global retail sales volumes are growing very slowly. While reported U.S. GDP for Q3 was 2.8% annualized, without the large buildup of business and farm inventories from lower consumer spending, it was likely only 2%. And, U.S. consumer sentiment for November is near a 2-year low.

At the same time, the Eurozone has lowered its growth forecast with unemployment still at a very high 12.2%, and anemic Q3 GDP growth of only 0.1%, including slower growth from Germany and France. The ECB recently surprised by dropping its key lending rate to a historic low of 0.25% from 0.50%, concerned also by the undesirable strength of the Euro and the risk of deflation.

Similarly, the Bank of Canada recently surprised markets in October by dropping its forecast for interest rates due to a lacklustre outlook for economic growth. Interestingly, and ironically, Canadian markets have so underperformed their U.S. counterparts, even while our interest rates are similarly at record lows (1% for the Bank of Canada rate), our Federal debt to GDP ratio is much lower at 36%, our Federal deficit is projected to be nil by 2015, our GDP growing likely at 2%, our jobless rate at 6.9% at a 5-year low, and we are rich in natural resources. And, we have already had our version of Obamacare for years.

Japan, still growing slowly, continues with its stimulative interest rate and money printing policies to revive from its deflationary economy of the last two decades. Corporate earnings there are benefiting. So is the Japanese stock market. And wages and real estate prices should start accelerating too, boosting consumption and investment.

Russia just cut its economic forecast for the foreseeable future to 2.5% annually and to only 1.8% for this year. On the other hand, more importantly, in the world’s second largest economy, Chinese GDP growth in Q3 accelerated to 7.8%. But, with inflation there at a 7 month high, monetary policy has tightened, driving government bond yields to 9-year highs, to rein in its housing bubble. Expectations are still for 7% growth going forward—lower, but still very impressive. And, over the long run, it is loosening its one child policy and encouraging continued movement of rural Chinese into cities, both to stimulate growth.

A Rocky Road, Inflation and Interest Rates

While interest rates in almost every developed country are at historic lows and supportive of bond and stock prices, the weak growth and, importantly, the low inflation stoking fears of deflation, are prompting the continuing stimulation from central banks. Inflation in the 17 nation Eurozone fell to 0.7% in October, the lowest since '09. Canadian inflation for October was also a concerningly low 0.7% annual rate.

In the U.S., inflation is running at about 1.2%, below the Fed’s 2% target, of concern to the Fed, and inducing it to continue its QE program of $85 billion of monthly bond purchases to stimulate the economy and inflation. Meanwhile, there are some disturbing outcomes from stimulation. U.S. house prices are rising, perhaps too quickly. In China and the U.K. also. U.S. government debt at about $17 trillion is equal to its GDP, and still rising, perhaps to $20 trillion by the time Obama departs. Adding in future social security and Medicare payments, total debt is over $100 trillion. The Fed’s debt is now almost $4 trillion. Lucky Janet Yellen, the new Fed Chief, a passionate reflationist, just said that the economy and labour market which are performing “far short of their potential” must improve before the central bank can begin reducing monetary stimulus. But these debt levels could be crisis making, which could ultimately result in a declining dollar, and significantly more inflation. And higher interest rates—as we have noted before, very bad for bonds, bad for stocks too— causing declining P/E ratios, though relatively better than for bonds (especially if rising rates are driven by good news) and, much better for commodities and their producers.

To get the Federal debt down would mean the U.S. government would have to increase revenues and cut spending, a prescription for lower growth in the future. But, of course, it could reflate. The reverse of the early '80s policies. The high inflation then (13%) and the combatant high interest rates (16% 30-year U.S. bonds) then instituted by Fed Chairman Paul Volcker were an anomaly. And the historically low interest rates today are also an anomaly, set to address the repercussions of global slow growth, including a Eurozone recession, low inflation and the risk of deflation, and accommodating excessively leveraged government and central bank debt.

Bonds are in a bubble. QE is not infinite, and ultimately, its tapering will have repercussions. Easy money often begets hard landings. Governments and central banks may find themselves between a rock and a hard place.

Rock Garden

There are some bright spots for sure. Cheap and more plentiful energy in the U.S. is one important one. U.S. manufacturing is becoming competitive, to the detriment of Europe and Japan, so that by 2015 more manufacturing jobs could start being created in the U.S. And average labour costs should be better than Japan, Germany and France. A lower U.S. dollar should contribute to U.S. economic growth and better earnings growth. U.S. corporations are strong, with good balance sheets and $1.5 trillion of cash. And U.S. consumers have seen their wealth increase from rising house and stock prices and their balance sheets have also improved with over $11 trillion of total cash on the sidelines.

Rock Climbing

And, talk about different points of view. Jim Rogers, a founder of the Quantum Fund with George Soros, and a venerable investor, believes all the money printing and debasing of currencies, is totally artificial, and will end badly. Andy Xie, a former Morgan Stanley economist, believes the global flow of hot money into government bonds and real estate has created an asset bubble greater than the one that unleashed the 2008 financial crisis, and when the Fed puts on the brakes it will bring on a recession worse than the last one.

On the other hand, economist David Rosenberg believes deflation is no longer a concern and is now bearish on bonds and more bullish on the economy and equities. He sees employment declining, some wage inflation and better economic growth next year of about 3%.

And one of our favourites, John Aitkens, is calling for a re-acceleration of global growth from global policy stimulus, allowing companies to start managing for growth and ROE, and is recommending an overweight in cyclical stocks and an underweight in bonds and defensive stocks.

Rock Solid

Our takeaway. Take advantage of market inefficiencies. Keep looking diligently under rocks for the currently unpopular, cheaper, good values. Today’s laggards are often tomorrow’s winners. Buy good values to provide a margin of safety. Be patient, it often takes time. Invest, don’t speculate. Clearly, avoid low yielding longer-term government bonds—they could be risky. Currently, have a bias favouring cyclicals over fully valued popular companies. Be patient, wait to buy at TRAC™ floors and sell at ceilings. Try to protect by shorting overvalued stocks and/or holding market put options, and cash too for the rainy days. Be skeptical, but flexible, and prepared to change strategies if the circumstances warrant. Do careful analysis, looking under rocks for the values, making sure they really are.

Herbert Abramson and

Randall Abramson, CFA

November 29, 2013

All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Trapeze Asset Management Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.

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