Market Outlook: S&P 500 And The TSX Venture

by: Matt Geiger

Summary

S&P 500 is Becoming Increasingly Overvalued.

TSX Venture Bottomed in mid-2013.

Bifurcation between Partnership and Market.

Market Outlook

I will start with the Partnership's designated "alternative investment of choice" - the S&P 500. For the past five years, investors in the S&P 500 have enjoyed fantastic returns and minimal volatility. It is also likely that this "easy money" will be available for some time. The path of least resistance certainly seems to be up. However, it is essential to remember that, even as the S&P's steady rise grows more and more intoxicating to the average investor, the past is not indicative of the future. This is not to say that a prudent speculator can't make money by buying at these levels and then selling at an opportune time in the next 1-3 years. But for those trying to build a nest egg or save up for a college education, this is not the place to be. In light of the below chart, you can't possibly believe that you're early to the party!

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The US macro backstop does not seem to support the rally. I understand that increasingly more of the S&P's revenues are being generated outside of the US (currently 45% of S&P revenues are from overseas), but one would think that the recently reported 2.9% decline in US GDP for Q1 2014 would have at least some effect on the exuberance. A glance at the above chart suggests otherwise. Additionally, as stated in the previous letter, the most significant data point that belies this rally is the dearth of U.S. Net Investment over the past decade. With Tesla's Gigafactory being a notable exception, the slump in capital expenditures (even in a period of record profits) does not bode well for the sustainability of this move.

A sharp decline in the velocity of money also behooves the current market environment. As demonstrated by the below chart, the velocity of the M2 Money Stock has plunged over the past five years. This is happening despite historically low interest rates and the Fed's multi-year money printing experiment that will continue through at least 2014. In his typically direct (and sometimes draconian) manner, John Kaiser concludes: "The people of America are paralyzed with fear about the future; the shriveling middle class has no spending power and the elite has no desire to spend its accumulating net worth. Banks are not lending because there is no vision of America's economic future, businesses are not investing capital because they do not see a growing consumption demand, and the wealthy are preparing to ride out the deflation that will accompany the return of interest rates to normal levels." There are notable exceptions to this statement (think Silicon Valley or the shale gas boom), but I agree largely with this sentiment.

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Trends keep working in the same direction until they don't. When a trend stops working, there is a reversal in the opposite direction. And the longer the original trend, the more painful the reversal (think 2000 or 2008). Whether the next S&P reversal occurs before or after the Fed ceases their omnipresent hand waving remains to be seen. But, one way or another, there will be a significant reversal in the near to medium term. This is the nature of our debt-fueled, boom and bust economy.

Switching gears to the resource market, it appears that the TSX Venture Index bottomed in mid-2013. (Remember that 80% of the Partnership's capital is deployed in mining equities, with many of these companies in the exploration/development stages. The TSX Venture Index is the best proxy for this market.) While determining a market bottom is an inexact science at best, the stages of capitulation we witnessed in 2012/2013 and the current market disinterest signals that, in the absence of a black swan event, the TSX has reached its lows in this current cycle. The below chart outlines the index's performance in this historic bear market.

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However, this "bottoming" needs to be taken with a grain of salt. The index as a whole is unlikely to zoom upwards anytime soon and many marginal companies will continue to decline for the indefinite future. There are still lots of dead beats out there. According to John Kaiser, 60% of juniors in the TSX Venture Exchange have $500k or less in capital. Companies with this amount of capital will have a hard enough time covering overhead, let alone making tangible development progress on their properties. Within a year there will be dramatically fewer choices in the resource space - these companies can only function as walking dead zombies for so long.

As this attrition continues over the coming quarters, in composite, the surviving juniors will be much stronger than the current batch. Bad bear markets are the perfect breeding ground for leaner and meaner indexes. There will be a time in the upcoming two years where a fresh wave of money enters the junior resource market, right as the remaining zombies are closing up shop. This decrease in variety of potential investments will be good for two reasons. The first is that institutions will begin to team up in financing the very best prospects, leading to strong shareholder bases all around. The second is that these surviving companies are poised for exciting outperformance. As these new investors reap killings in the junior space, more money will find its way into resources as the cycle shifts into a bull market. The Partnership looks forward to waiting patiently as this process unfolds.

One of the most frustrating aspects of the past few years has been the high correlation between all mining related equities. Regardless of the company's fundamentals, the only direction for the past couple of years has been down. This is a terrible situation for investors attempting to cherry pick the very best from a larger universe of companies. (I am a strong believer in Pareto's Principle, or the "80-20 Rule". This rule of thumb dictates that 80% of any industry's profits are generated by the best 20% of the companies. Extending that further, 64% of an industry's profits are generated by the best 4% of the companies.) That being said, this concept was temporarily defied in the previous few years as all mining equities traded lower in tandem.

The exciting news is that bifurcation is now very real between the Partnership's current holdings and "the rest". This is the "stealth rally" that Rick Rule often references - and it has really come to life since November 2013. I've provided some charts below to demonstrate this marked change of performance since late 2013. For points of comparison, I also provide the aggregate performance of past holdings of the Partnership (that have been liquidated due to poor operational performance) and the TSX Venture Index as a whole. Keep in mind that these charts assume equal weightings between all Partnership holdings. As evidenced by the upcoming Overview of Partnership Holdings section, this is a simplification.

Current Holdings

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Past Holdings

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TSX Venture Index

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.