Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec | YTD | |
---|---|---|---|---|---|---|---|---|---|---|---|---|---|
2024 | 1.74 | -1.70 | -1.26 | 0.93 | 0.24 | 0.26 | 2.57 | 2.36 | 1.82 | 4.15 | 3.40 | 1.85 | 17.45% |
2023 | -3.42 | -.95 | -0.11 | -0.07 | -3.19 | 2.22 | 1.57 | -0.22 | 2.06 | -0.76 | 2.21 | 1.18 | 0.32% |
2022 | 1.15 | 1.02 | .93 | .10 | -1.61 | .82 | -1.61 | -0.33 | -8.49 | 0.06 | -.09 | 0.68 | -7.5% |
2021 | 3.40 | 3.99 | 3.75 | 1.27 | 1.30 | 1.54 | 0.22 | 1.51 | 4.89 | 3.70 | 0.50 | 1.20 | 30.78% |
2020 | 0.41 | -.20 | -1.91 | .74 | 1.66 | 2.25 | 1.26 | 3.13 | 1.10 | 0.57 | 2.04 | 3.15 | 15.02% |
2019 | 1.72 | 1.79 | 3.13 | 1.15 | 1.35 | -0.75 | -1.54 | -1.34 | 0.04 | -1.45 | -2.57 | 1.39 | 2.76% |
2018 | 6.36 | 4.81 | 0.95 | 0.71 | -0.85 | -1.07 | 2.50 | 1.69 | 3.53 | 0.67 | 0.02 | -0.18 | 20.58% |
2017 | 0.27 | 0.05 | 0.35 | 0.25 | 1.39 | 1.45 | 1.77 | 0.12 | 3.27 | 3.61 | 13.96 | 1.96 | 31.51% |
2016 | 1.59 | 3.30 | 1.53 | -0.82 | 5.67% |
Dear Partners,
For the month of December, Caravel returned +1.85% compared to -2.83% for the benchmark (-2.39% for the S&P 500 & -3.27% for the SPTSX)1. This brings full-year 2024 net return to +17.45% for the fund and +23.43 % for the benchmark, respectively.
If November was a party, December felt like a hangover for most risk assets. Stocks and bonds suffered from renewed inflation fears, subsequently reduced expectations for further Federal Reserve easing in 2025, and a strong US Dollar colliding with high valuations in the large cap US equities that now dominate the global stock market. We managed to navigate a volatile December through a combination of strategies. Our ever-present hedges and risk management tools, which as we have written are often a drag on performance, contributed +0.60% of gross return. We maintain substantial hedges to protect against further downside for our key markets in the first quarter of 2025. We also saw gains from our fixed income & convertibles (+0.90% gross), merger arbitrage (+0.60% gross), equity long-short (+0.50% gross), and relative value arbitrage (+0.40% gross) strategies, while our commodity exposed positions were a drag of approximately -0.35% on performance. Our credit and convertibles portfolio remains focused on short duration, high issuer quality, and wide credit spreads, which helped insulate us from the 9% increase the US 10-year yield saw in December. The confluence of these factors allowed us to end a good year on a strong note.
Our 2025 Outlook
For starters, we don’t fancy ourselves market strategists or forecasters. We certainly won’t be making any big bets on specific macro-level outcomes. However, we hope that sharing our outlook will shed some light on why we are currently focused on more event-driven and market-neutral strategies with our excess capital (more on this later).
From its closing high of ~6,090 on December 6th, the S&P 500 pulled back about 5% to 5,800 when I began writing this letter. It has since erased those losses and is currently at an all-time high again. At these levels, the index is trading at about 22.5x estimated 2025 earnings, good for an earnings yield of 4.44%. As I check my Blomberg terminal, the US 10-year treasury is yielding 4.65%. We have written about the so-called ‘equity risk premium’ (‘ERP’) that investors have historically demanded to hold stocks, given their inherently higher risk profile when compared to US government debt. The current reading is -0.21%. Over the past ten years, that premium has typically ranged from +2% to +5%, but has been in steady decline since COVID (see chart on page 2).
Source: Bloomberg LP
In Q4 2019, consensus 2020 earnings for the S&P 500 (‘SPX’) were $180. The index closed 2019 at an approximately 18x multiple, or a 5.6% forward earnings yield, while the 10-year was trading around 1.9%. This equates to an equity risk premium of 3.7% and constitutes what we could call a setup somewhere between fair and favourable for the index. History supported this, with the SPX nearly doubling over the following 6 years, good for a ~13% CAGR over that period (14.5% including dividends). Consensus earnings for 2025 are now sitting around $270, or 50% higher than they were six years ago. In other words, earnings growth has accounted for only half of the increase in the price of the SPX since just before COVID, with the remainder coming from multiple expansion. The earnings yield on the SPX is down 15% over the past 6 years while the ‘risk-free’ rate is up over 150%. While it has been a widowmaker trade to bet against US stocks, it is our belief that this dynamic cannot continue indefinitely. We believe something needs to give, and either US bond yields or US stock market multiples (or possibly both) are likely to trend lower from here to the end of 2025.
We have direct exposure to only 1/500 constituents in this index (long UBER calls), so why should we care? We care because, as we have previously noted, correlations tend to converge towards 1 in market downturns, and accordingly we would expect some of our positions to suffer during a sustained exodus from SPX. This is why we hedge, and why (we believe) we have been able to comfortably manage the market volatility we saw in August, December, and January.
If I had to throw a dart, I would expect 2026 EPS estimates for the SPX to converge around $300, barring a recession this year. This would mean 10% year-over-year growth vs. 2025 expectations (for reference 2025 expectations are around +14% vs. 2024). This represents above-trend earnings growth owing to the concentration of high-quality cash flow compounders at the top of the index (think Mag7/AI). Based on this, I’d peg fair value for the index at 6,000-6,300 by year-end 2025 (4.75%-5.00% forward earnings yield), assuming the 10-year yield comes off the boil such that the equity risk premium can be marginally positive again. At the midpoint, let’s say 6,150 SPX. I anticipate US bond yields would have to pull back to ~4.0% or so in order to support this hypothetical valuation for the stock market. This is largely consistent with a ‘soft landing’ thesis, and would be unlikely in the event of a material weakening in the US economy. Under that scenario, we expect $300 EPS will prove lofty and SPX in the low 5,000’s is a likelihood.
Canada is a different story. We flagged how relatively cheap the TSX was last summer at approximately 13.0x forward earnings. That multiple is now 15.5x. We believe the political sea change currently underway in Canada is likely to have positive implications for Canadian consumers, businesses, and investors. As such, we continue to focus our ‘stock-picking’ efforts in the Canadian market versus the US, at the margin. We are carefully monitoring international trade relations and currency markets, which we see as the biggest (two-sided) risks for Canadian stocks in the short-term.
As a result of our cautious stock market outlook, we have been dedicating most of our time and energy lately to strategies that are more event-driven/market neutral. These include merger arbitrage, credit, convertibles, and special situations. We believe pro-business administrations on both sides of the border will reduce the risks inherent in corporate mergers, leading to an increase in deal supply and less relative competition eating away at spreads. We also believe (unsustainably) high base interest rates will offer attractive entry points for certain corporate bond issuers. We currently have over 80% of our gross capital allocated across these strategies and look forward to reporting on their performance over the coming months.
At the end of December, Glen redeemed CAD $300,000 (approximately 3%) of his holdings.
Overall, we are looking forward to 2025 and beyond. We thank you for your continued partnership and support.
Sincerely,
Jack and Glen
Managing Partners, Caravel Capital
1 Benchmark = 50/50 weighting of S&P 500 & SPTSX Composite Indices