Risk/return forecasts favour corporate bonds over equities
We continue to believe that earnings forecasts for US companies are too high. In addition, while equities should post positive, if modest, returns over the next 12 months, US corporate bonds appear to offer a more attractive option for investors when risk considerations are taken into account.
While we believe the recession is over, we anticipate that economic growth will remain below trend for the foreseeable future. In addition, growth forecasts for 2011 in general are being revised down while those for 2010 are increasing. However, while it is important for investors to have a view of the potential for future returns, which will inevitably be affected by the overall economic environment, being aware of the underlying risks related to equity investments is also critical.
In terms of potential returns, the chart in the next column shows that the current 12-month forward PE of 12.2 (market consensus) appears relatively attractive. However, since 1985, the average year-over-year return amounts to around 21.3% (light blue box). Turning to risk, about two thirds of returns were found between 7.8% and 34.8% (dark blue bar).
However, as we pointed out in a previous Daily Theme (25th June 2010), we believe that the current consensus earnings growth forecasts of 15.4%, despite being revised downwards, are still too high. Indeed, we are assuming earnings growth of between 10% and 12%, reflecting our relatively downbeat view of the economic recovery. Consequently, we have a 12-month forward PE in the range of 12.9 to 13.2, based on the current price of the S&P 500.
As the chart below indicates, historic equity returns have been fairly low at these valuation levels, i.e. at around 7.9% per annum, and the range of returns significantly broader (between -13.4% and +29.2%). The Sharpe Ratio is a broadly used measure to adjust return potential for the underlying risks. Risk-averse investors seek a high multiple, since the ratio compares the units of historic returns to units of risk. Equities do appear less attractive than corporate bonds on a risk-adjusted basis at the current forward PE level.
Conclusion
Given the uncertain economic outlook, risk considerations are of considerable significance, and US corporate bonds currently represent a more attractive investment than US equities. Certainly, corporate bonds have delivered similar returns to equities over the long term, while experiencing much lower levels of volatility.
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