2021 June CAD

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1.54% MTD

16.20% YTD

The stock market can remain irrational longer than you can remain solvent.

- John Maynard Keynes

Dear Partners,

For the month of June, the Caravel Capital Fund Ltd was up 1.54%.

The gains this month were generated primarily from our Merger Arbitrage, Warrant, and Capital Structure Arbitrage strategies. The fund suffered losses on a short position in anticipation of the company’s restructuring. We are confident the company we are short will issue upwards of 400% more shares in order to pay down its debt. Debt restructuring strategies have been one of the largest contributors to the fund’s profitability over the past 5 years, and we expect this trend to continue.

Follow the Money

Before we delve into a sobering analysis of what we see in the coming months (or weeks), we want to explain how we determine if major indices are expensive or cheap.  With this insight, we hope you will better understand the basis of our systematic risk management.

Stock index levels like 4,300 for the S&P 500 or 34,000 for Dow Jones are just a culmination of the total equity value of companies who are members of the respective index - 500 companies in the S&P and 30 companies in the Dow. The S&P's value is calculated by adding together the 500 constituent companies’ market capitalizations (the market capitalization is just each companies’ total shares outstanding multiplied by their share price) and applying a common denominator to get to a smaller, more manageable number, like 20 for example. As the members' share prices go up, so does the level of the index. It’s useful to know this denominator can be used to measure the fundamentals of the index too.  Using the common denominator, we can speak in terms of an entire market’s earnings or EBITDA, and express the market's value in terms of multiples of those metrics.  Using this knowledge, you can decide if the “Whizz Kids” (Meme/Reddit Traders, Influencers, Robinhooders, and TickTokers) should be cheering or fearing the current North American markets.

“Just the facts Ma’am”

- Joe Friday

From 2013 to 2021 the S&P500’s earnings rose from $106 to $142 (as of today), a gain of 34% over 8 ½ years.  During that same period the S&P 500 index rose from 1460 to its current 4360. A gain just shy of 200% over 8 ½ years.  Putting it another way, in 2013, when overnight interest rates were 0% and 10-year money was 1.5% (both roughly the same as today) investors paid $13.77 for every $1.00 of earnings of the S&P 500.  Today, investors are paying $30.70 for the same $1.00 of earnings. In risk management terms, under similar economic conditions, the price to earnings ratio has gone from 13.8 to 30.7 in 8.5 years.

Professional Investors, however, buy shares based on the earnings one year forward not the trailing twelve months. The earnings for the S&P 500 are forecasted to be $190 in 2021 and for 2022 they are forecasted to be $213.  Since it's the middle of 2021, let’s split the difference and say earnings will be $200 over the next 12 months.  The pros are paying $21.80 per share for the dollar of the next year's earnings that they only paid $14.60 for at the beginning of 2013. That's a 50% increase in cost! Put another way, the pros are willing to accept 33% less value for the same amount of earnings.  Shame on you Neanderthals.

An Ugly Truth

In 2013, 2014, 2015, 2016, 2017, 2018, 2019, and 2020, or every year considered above, the actual earnings of the S&P500 NEVER REACHED THE FORECASTED AMOUNT.  NEVER!!!  Based on that, investors aren’t paying 50% more for the same stock market - try 65% more than they did in 2013 under similar economic conditions.

For those of you who are savvy with financial mumbo jumbo, the S&P 500 index traded at 7.9 times EBITDA (earnings before interest, tax, depreciation, and amortization) in 2013.  Today investors pay 13.6 times EBITDA for those same shares.  That’s 72% more for the same EBITDA!  Why the big difference?  Recall when things were awesome and the global economy was rocking in 2017, the U.S. government chopped corporate taxes, which allowed a higher percentage of EBITDA to become earnings, so earnings went up, and then stocks went up, but EBITDA didn't go up.

Ok, so now we have fact-based knowledge that the biggest most profitable companies are 50 to 70% more expensive than they were 8 ½ years ago.  We also know that over this same time, not once did the actual earnings ever reach the forecasted amount.  I repeat not once! 

Be Brave, This Might Sting a Bit

Investors are paying prices for stocks like they have Jeff Bezos' money.  We also know that G-7 governments have increased their national debts between 50% and 100% since 2013, and we know that US corporations were given major tax breaks in 2017 which pushed up the prices of their common stocks.  NEWS FLASH!  On July 1^st 2021 (like two weeks ago) 130 O.E.C.D. countries signed a binding accord to set a minimum global corporate tax rate of 15%.  Mark our words, this will have a negative impact on future earnings!

Uhhh Ohhh!  Summary Time!

• We have Reddit and Robinhood treating stocks like a casino.
• Central banks are gently telling us that overnight interest rates will go up next year. 
• Central Banks are also telling us they will stop holding long term interest rates down (the ending of quantitative easing).
• 130 OECD Countries have just reached an accord to turn the tables on global corporations and no longer offer them lower tax rates or havens.
• Higher taxes translate into lower earnings at a time of historically high valuations.

If we drop earnings by the amount they went up because of the tax cuts, and also drop the multiple paid for those smaller earnings to historic average levels of 17 to 18 times, stock prices will fall precipitously.  Similar to the end of the roaring ’80s and the end of the Dot.com era in 2001, we are nearing the end of the 2020 internet revolution for stocks.  Does this happen next week, next month, or even in 1-3 years, we don’t know.

 What we all know is when earnings fall 15% from $200 to $170 and investors decide that 18 times forward earnings is a reasonable multiple, then we can take 18 and multiply it by 170 and we get 3060 on the S&P 500 index. That equates to a 30% drop from here.

One last tidbit:

“Markets always overshoot the rational case, regardless of direction.”

- Jeff Banfield

We really wanted to keep this letter short but we didn’t have the time. Given that it's summertime, we thought you may indulge, so we went there. We will continue to protect your capital while you enjoy your summer.

We thank you for your continued confidence and capital.

Glen & Jeff - Caravel Capital