Chief Investment Strategist
Summary: In this equity update we focus on US equity valuations which have recently sparked renewed interest by many investors and the current 12-month forward P/E ratio on S&P 500 has been used as an argument for why US equities will not deliver good returns the next 10 years. We go through the arguments and show why that is a stretch, firstly because the analysis ignore earnings growth itself, but secondly because equities have to be measured against bonds which are the natural alternative. Compared to bonds, US equities are still offering an attractive risk premium and we remain overweight and positive on equities.
Almost 11 years as a professional in this industry has taught me that most investors rarely think their arguments to the end and apply statistics in a questionable way. Recently several leading news media and key people in the industry have floated the chart below, showing the subsequent 10-year annualised return from a given starting level of 12-month forward P/E ratio on the S&P 500 using data since January 1992. The line marks the current 12-month forward P/E ratio just below 22. Several market commentators have used the regression line going through zero return based on historic data to indicate that US equities offer a poor risk-reward ratio. But the statistical truth is that the prediction interval around these points is quite wide and that the 10-year annualised return from the current level could be anything from -2% to +5%. In other words, the valuation level alone is not worth much except as a ballpark estimate of what lies ahead.
Another important thing to consider is that the current Q1 earnings season has shown that analyst estimates have been too conservative. It could be that the current 12-month forward P/E ratio is way off if those earnings expectations fail to model the massive impact on earnings growth from the current fiscal regime. As you can see, there are many variables at play in such a simple chart.
The next level analysis is to recognise that equities do not behave in isolation but is part of a complex financial system where the most prevalent alternative is bonds. If take the inverse P/E ratio we get the earnings yield, a crude proxy for the implied equity return, and compare it to the yield-to-worst on 7-10Y Treasuries then we get a simple implied equity risk premium. This simple model fails to incorporate earnings growth as the inverse of the forward P/E ratio gives you the perpetual earnings yield. Leaving that aside for a moment, because it does derail our point, we can now compare the implied equity risk premium to that of the subsequent 10-year annualised return between US equities and US 7-10Y government bonds. The implied equity risk premium is basically measuring what we can expect in terms of equity returns over bond returns given the current equity valuation level and prevailing bond yield.
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Head of Commodity Strategy
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Head of Fixed Income Strategy
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Head of Commodity Strategy
Quarterly Outlook
Chief Investment Strategist
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)