What about the ‘Great Canadian Short?’  The Gold sector has not been the only problem dogging Canadian stocks lately.  On top of the weakness in resource stocks, our banks have also been under attack.  One of the more popular trades lately for U.S. hedge funds has been to short Canadian banks while going long U.S. banks. 

Hedge fund manager Steve Eisman made his reputation with his short bet against subprime mortgages prior to the credit crisis in 2008.  Eisman, founder of Emrys Partners, said the U.S. housing recovery is in its early stages and offers plenty of investment opportunities.  But Eisman is bearish on the Canadian housing market, saying that it’s starting to crack after showing resiliency throughout the U.S. housing downturn. If it continues, the trend could hurt big Canadian banks like TD Bank Group (TD) and Royal Bank of Canada (RY), which trade for more than twice tangible book value, way above the valuation of most large U.S. banks. Particularly vulnerable, he asserts, is Home Capital Group (HCG.Canada), a lender specializing in high-risk mortgage loans that aren’t eligible for guarantees from the Canadian equivalent of Fannie Mae. At about $53, it trades for twice tangible book. “If housing rolls over, this company will have problems.”

Taking the opposite side of U.S. hedge funds is a risky strategy in the best of times, due to their sheer size and momentum.  However, we don’t think that the funds initiating these trades know the Canadian housing market well enough and haven’t factored in the differences in lending practices here versus the U.S.  As the major Canadian banks report their 2nd quarter earnings, the CEO’s have been pointing out the higher lending standards of the Canadian market, the greater level of home equity here (over 80% of homes have loan-to-value ratios of under 75%) as well as the fact that the banks know their customers better here, as opposed to the U.S. system where loans were packaged up and sold to 3rd parties who had no real idea what the quality of the underlying assets were.  Moreover, the U.S. real estate market had a boom far in excess of the gains in Canada due to excessive levels of speculation and ‘creative financing’ techniques.  When the bubble finally burst in the U.S., there was much further to fall.  Whlle the Canadian housing market is clearly in a slowdown, the excesses here (as is typical in Canada) have not been as great.  Consequently the downside will be limited as well.  Canadian banks have also diversified internationally and have greater insulation from the impact of housing.  With valuations back below global levels, earnings still growing, dividends rising and capital levels strong, the Canadian banks still look like a good investment.  We have recently added to positions in RBC, ScotiaBank and TD.

While the movements and interpretation of actions by the Fed may lead to more volatility in stocks over the next few months, we continue to believe that the overall direction of the market over the next few years will continue to be higher.  Not only because the global economy is recovering, but because stocks remain cheap!   This is the 3rd time that the S&P500 has flirted with the 1600 level over the past 13 years.  While the prior two occasions proved to be market peaks, look at the difference in the underlying metrics of the stock market in each case as shown in the table below.  Earnings are substantially higher than they were at the prior peaks and interest rates are much lower.  Those conditions are both supportive of higher stock prices and suggest that there is a much better chance that these levels hold this time around and that the market pushes ahead.

S&P500 Index S&P500 Earnings 10-Year Bond Yield
2000 Peak 1530 $54 6.10%
2007 Peak 1565 $83 4.70%
2013 1600 $108 1.80%

Also, the global economy headed into recession less than one year after those prior peaks.  Today we believe we are still early in the global economic recovery, another reason to support higher stock prices going forward.

Looking at the market in another way, we use the Equity Risk Premium (ERP) to determine the difference in valuations between stocks and bonds.  The ERP is basically the additional return that the market is effectively requiring from stocks versus bonds at current levels.  The higher the ERP, the greater the excess return required for stocks.  In other words, how much more in earnings yield would you receive from owning stocks versus the guaranteed return you could get from bonds?  The chart below shows the ERP near record levels right now, just a touch below where it was when the stock market bottomed in early 2009, which had been the highest in the prior 30 years.  Bottom line; unless interest rates are about to head dramatically higher, stocks are as cheap as they have been in a long time!

Stocks Still Cheap Compared to Bonds

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