The Lato Letter: Volume 2, Issue 8.

The Lato Letter: Volume 2, Issue 8.

There are many adages thrown around the investment industry. One is constantly in the press these days and the other should bring warning signs when it is uttered.

The first adage that I am sure you have heard many times recently is “Sell in May and go away”. I will ignore the warning that I mentioned above and use the other adage to make the following utterance, “it’s different this time”. Unlike 2010, 2011 and 2012, I do believe that this May is different. I will highlight some of the points made last week by Thomas Lee, the JP Morgan equity strategist on this subject, in his weekly piece.

Lee wrote that there is a significant difference among what investors are being offered by stocks, high grade bonds and high yield (junk) bonds. The comparative measure that was used was the Price/Earnings (P/E) of each category. To better understand this comparison, let me step back a minute and explain his methodology.

The P/E ratio for a stock is the price of the stock divided by the earnings of the company. In this case, the P/E of the S&P 500 index was used and that current forward P/E is 13.9X. In order to compare this P/E to bond yields, the bond yield must be “inverted” to arrive at a P/E. For example, a bond priced at $100.00 and paying $5.00 of interest would be yielding 5% or have a P/E of 20.0X (Price of $100.00 divided by Earnings of $5.00 = P/E of 20.0X).

The comparisons to the current P/E of 13.9X for the S&P 500 are 29.5X for the High Grade Bond Market and 18.0X for the High Yield Bond Market. Over the last few years, as investors have stretched for yield in this low interest rate environment, they have gravitated to High Yield Bonds and dramatically increased the spread between stocks and High Yield bonds. The following table from the JP Morgan report depicts the change in the relationship of the P/E of the S&P 500 to the P/E of High Yield bonds from 2009 to now:


As you can see, the spread between stocks and High Grade bonds has gone from a modest discount in 2009 to a huge discount today and the spread between those same stocks and High Yield bonds has gone from a premium in 2009 to a discount today.

Investors have embraced the risks of higher yield bonds in their search for yield but in spite of the equity markets at all-time highs in the US indices, investors have yet to fully embrace the risks and the rewards afforded to them by equities. That is one reason why it is different this time.

Another major difference and a second reason why it is different this time, is the measure of Hedge Fund Beta and the use of it as a contrarian tool. Again to step back, hedge funds have the ability to buy stocks (bullish) and to also short stocks (bearish) in addition to holding cash and borrowing money to increase their leverage to either view: bullish or bearish. Their beta is calculated by multiplying -1 times the percentage of the hedge fund’s capital that is dedicated to short positions (bearish), zero times the percentage in cash and 1 times the percentage of the hedge fund’s capital that is dedicated to holding stocks (bullish).

The chart below shows Hedge Fund Beta going back to the beginning of 2010. As you can see, Hedge Beta peaked in April 2010 concurrent with the peak in the S&P 500 and essentially followed the same pattern in 2011 and 2012. This year Hedge Fund Beta is actually below zero, approaching levels last seen in August 2012 at the current 52 week low.


There are obviously many studies that one can show to present their view of the market. However, these studies present a view that very much coincides with my longer term outlook that stocks continue to be fairly valued. Other investment alternatives are relatively unattractive and investors remain very nervous and lack total conviction to the risks and rewards of equities.

At the end of the day it is the return of individual companies making up a portfolio that generate the return of that portfolio. It is the growth of earnings of those companies and the market’s valuation of those earnings that drives the return. Obviously, a more favourable market environment helps that happen but fundamentally it is the performance of the underlying business that is the primary driver.

I continue to believe that the equities held by Padlock clients represent solid companies at attractive prices that should continue to generate positive returns in the current environment.

Although I have suggested that investors should not sell in May and go away, I am not fully taking that advice. I will not be selling but I will be going away. Gini (my wife for those that don’t know her) and I will be celebrating our 35th anniversary on a trip to Viet Nam and Thailand. I will be leaving on May 9th and returning to the office on May 28th. In this age of wonderful communications, I will be keeping abreast of things and will have phone and email access should you need to reach me for any reason.

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change without notice.

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