Stock Talk Podcast Episode 283 Show Notes

KeyStone’s Stock Talk Show Episode 283.

Great to chat with you again this week with our first regular show of 2025. I will kick off the festivities with a look at general market valuations to start 2025. Aaron will answer a viewer question on Navigating International Equity Allocation.  Brennan will provide a preview of a report he authored on the telco industry in Canada. And finally, Brett will take a frequently viewer question on whether you should use leveraged ETFs.

Let’s get to the show – I welcome my cohost, Mr. Aaron Dunn, and killer B’s, Brett and Brennan!

Our Poll Question this week?

Market Outlook

Shiller PE Ratio: General market valuation indicator.

For a general overview of current market valuations in a historical context, we often use the Shiller PE. Prof. Robert Shiller of Yale University invented the Shiller PE Ratio to measure the market’s valuation. The Shiller PE can be a more reasonable market valuation indicator than the PE ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. This is like a market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.

The current Shiller PE is 37.9, 41.8% higher than the recent 20-year average of 26.7.

20-year low: 13.3.

20-year high: 38.6.

 This is the Shiller PE on the S&P 500 all-time. 

While the Shiller PE is not at all time highs, it is currently at or near the top 3 levels all time indicated the markets are generally expensive on average.

 Here we can see that the ratio is also basically trading at 10-year highs.

Presented here are several additional data points indicating the S&P 500 is historically expensive on average today:

•  The S&P 500 currently ranks in the top 1, 2, or 3 in price-to-earnings, price-to-sales, price-to-book, and dividend yield metrics over the past 60 years.
•  The 12-month trailing PE ratio of 25.5 is the fourth highest since 1954.
•  The price-to-sales ratio of 3.3 is the highest since 1990, and the price-to-book ratio of 5.3 is the second highest since 2000.
•  The dividend yield of 1.23% is the second lowest since 1970.

 Additional thoughts.

•  Today, while we continue to uncover and monitor many great Canadian & U.S. Small Cap businesses, the combination of quality, growth, reasonable valuation, and strong balance businesses has narrowed considerably.
•  The primary culprit has been a rising general market which saw the S&P 500 jump over 24% YTD in 2024 and the S&P TSX up just over 17% over the same period.
•  As detailed in the commentary above, the general gains have pushed valuations to the high end of historical norms giving KeyStone reason to be cautious in the near-term and continue to MONITOR for entry points rather than jump in and introduce new quality names at elevated valuations or take undue risk on more speculative names at decent but riskier valuations.

While the potential for a “Santa Claus” rally to start 2025 with the promise of tax cuts boosting US earnings under Donal Trump, the general environment at present which includes a potential tariff war (uncertainty within Canada & potential inflationary pressure), slower economic conditions, and high historical valuations should tip the scales for investors into a more cautionary stance near-term for investors.

Overall, there are a number of quality stocks we would like to buy at some point in 2025, but given the above, require significant pullbacks to enter with a reasonable margin of safety. In fact, we have a U.S. Small Cap service set to launch and several stocks we have identified as quality long-term businesses but continue to monitor for better entry points.

Telecom Teaser

Today on the podcast I am going to tease the 2025 Canadian Telecommunications Special Report that Aaron and myself have been putting together for clients and is expected out this week. This report was essentially spurred from a client’s question during one of our Canadian Income Stock Chat sessions who stated “they had sold their position in BCE given they were not happy with the direction of the company”, and asked for a general comparison of all the Canadian telecoms.

Just to make sure listeners are aware, BCE was not a recommendation of ours, but we get many questions from clients on the telecoms as they hold one or two in their portfolio. So I spent several hours over the weekend reading industry reports, running numbers and writing the report itself.

In the report I ran the TOTAL RETURN CAGR of each telecom over the past decade, and essentially all of them underperformed the TSX Total Return Index….. with only one of them able to perform similarly to that of the index….

And here is a look of the fundamental comparison table which I go over in the report. Obviously in the report the table is completed without the question marks in it. But there were certainly a few takeaways that I address, which revolve around the dividend yields, payout ratios, ability to grow their dividends. As well as looking at debt loads, market share, and overall market valuations. I also compare their FY 2024 guidance, and expect to do a bit of an update for clients once they all report their FY 2025 guidance in the upcoming weeks.

If someone is interested in the space, I certainly think that it will be a good read. I am proud of the work I put in for clients and again Canadian Income stock subscribers can look forward to that report in their inbox later this week.

Leveraged ETFs

1. We get questions quite frequently on whether you should use leveraged ETFs.
   I’m going to go through how these products are structured and whether or not you should even consider using them.
2. Leveraged ETFs come in various forms but function in similar manners. They will target a multiple of an asset return whether a stock an index or another ETF for a set time period. The multiple will range from 3 times down to -3 times. For a 2x leveraged ETF if the underlying asset returned 25% the leveraged ETF will target a a return of 50% for that time period and if it were -2x the leveraged ETF would turn -50%. The managers of the funds generally use swaps, a type of derivative to achieve this effect, but if it makes it easier to think about you can think of it like a margin account, taking a loan to buy more shares.
3. The time period is how often the ETF resets its leverage. It is generally one day, but there are some monthly reset periods. This factor is very important as the leverage will drift away from the targetted leverage intra-period but the more frequent the reset period the higher the volatility decay. Volatility decay or Beta slippage is simply the loss of value due to the the rebalancing to a set leverage.  If you allow leverage to move freely, and you are long, if the asset drops your leverage increases.
4. A simple example with high volatility is if you have a 2x long position on a stock and it drops 25% you have lost 50%, and your leverage would now be 3x assuming the position is still intact. So if the benchmark asset were to rise 33% returning to the initial value. However, if you have a fixed leverage which resets this will not occur. If we do the same drop 25% and then increase 33% of the benchmark asset the 2x leveraged ETF that resets would have a negative return of 16.7%. If we were to extend this pattern out to more periods where the stock goes up then down to the same price the more frequently the period so daily vs weekly or monthly leverage resets the more volatility decay will occur.
5. Here is a table for a 3x leveraged fund’s expected performance given the volatility. It is a lot of numbers, but the dark gray is where the fund would underperform its targetted return and the light gray is where it would overperform. A key takeaway, the higher the stock price volatility the worse leveraged funds will perform. Even if you are directionally correct as in you buy a long leveraged ETF and the benchmark asset appreciates if volatility is high enough you will underperform the non-leveraged benchmark on the other hand if there is no volatility or little volatility the leveraged fund can outperform its targetted return over multiple periods.
6. Shifting to a real-world example with Microstrategy, the highly volatile Bitcoin holding company that has both long and short 2x ETFs available. MSTU for 2x long and MSTZ for 2x short. Since November 13th the stock has returned -3% effectively flat as far as Microstrategy goes. But both the 2x 0long and 2x short ETFs have had a negative return of 32% and 49% for the long and short ETFs respectively. This is volatility decay as the underlying, Microstrategy shares have been extremely volatile during this period.
7. If we zoom out to when both these ETFs originated on September 18th, Microstrategy shares returned 142%, the 2x long returned 243% and the 2x short returned -96%.  Whereas at Microstrategy’s peak price on November 20th of $474, a return of 257% since the ETFs started trading, the 2x long had a return of 906% well over the 2x, as the return well exceeded the volatility decay.
8. The point of all this is to show how much your holding period matters when it comes to these financial instruments and why daily leveraged ETFs should generally not be used for long-term holdings as the return may deviate significantly from the expected return.

You can view yourself as being short volatility when buying a leveraged ETF as increased volatility will negatively impact you.
A combination of higher leverage, more frequent leverage reset periods and higher volatility the worse-leveraged ETFs will perform regardless of the direction of movement of the benchmark.
Overall these instruments are really designed for trading not for long-term holding over multiple leverage reset periods, so if you have a buy-and-hold mentality like KeyStone does they aren’t worth using.