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The S&P 500 is trading at about 22 times forward earnings and this seems prohibitively expensive for investors. One strategist, however, believes current U.S. stock prices are not only justified, but set to move significantly higher after a period of consolidation.

Andrew Garthwaite is the global equity strategist at Credit Suisse and has frequently earned the No. 1 ranking in his field in the annual Institutional Investor survey. His current forecasts, outlined in a 47-page report on Thursday, is for a correction in growth stocks in the short term followed by a significant ramp higher.

His midterm bullishness results from the relative attractiveness of bond yields and equity profit growth. Specifically, Mr. Garthwaite believes that inflation-adjusted U.S. bond yields are so low that investors are highly incentivized to buy equities and drive valuations higher.

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The concept of equity risk premium (ERP) is the dominant force behind Mr. Garthwaite’s outlook. In basic terms, ERP calculations answer the question: “How cheap do equities have to be to entice investor assets away from risk-free bond investments?”

There are many inputs into the strategists’ formula for ERP but thankfully he provides a shortcut (or in his words, “an easier way to look at this”) which is shown in the accompanying chart.

Inflation-adjusted yields

driving valuations higher

S&P 500 forward

P/E ratio

U.S. 10-year Treasury

real yield (%,inverted)

25

-0.8

-0.6

23

-0.4

-0.2

21

0.0

0.2

19

0.4

0.6

17

0.8

1.0

15

1.2

13

1.4

2015

2016

2017

2018

2019

2020

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE:

scott barlow; credit suisse; bloomberg

Inflation-adjusted yields

driving valuations higher

S&P 500 forward

P/E ratio

U.S. 10-year Treasury

real yield (%,inverted)

25

-0.8

-0.6

23

-0.4

-0.2

21

0.0

0.2

19

0.4

0.6

17

0.8

1.0

15

1.2

13

1.4

2015

2016

2017

2018

2019

2020

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; credit suisse; bloomberg

Inflation-adjusted yields driving valuations higher

S&P 500 forward P/E ratio

U.S. 10-year Treasury real yield (%,inverted)

25

-0.8

-0.6

23

-0.4

-0.2

21

0.0

0.2

19

0.4

0.6

17

0.8

1.0

15

1.2

13

1.4

2015

2016

2017

2018

2019

2020

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; credit suisse; bloomberg

The purple line represents the forward price-to-earnings ratio for the S&P 500. The blue line tracks the inflation-adjusted yield on the 10-year U.S. Treasury bond (note that it is plotted inversely to better show the trend – a rising line indicates a falling real yield).

The chart shows that from December, 2016, to July, 2019, real yields and the P/E ratio tracked reasonably closely – lower yields led to investors paying higher stock prices for expected earnings and the reverse case also held.

A major dislocation on the chart began in December, 2019. The P/E ratio fell rapidly while yields continued to fall. Investors diving out of equities and buying bonds as the COVID-19 virus spread globally is almost certainly the cause of this divergence.

Thanks primarily to the Federal Reserve, Bank of Canada and other central banks, order was restored in global markets in the third week of March. The S&P 500 has been climbing since, and the P/E ratio jumped from 14.2 times forward earnings estimates on March 20, to the current 22.3. Interestingly, the P/E ratio is now very close to where the chart suggests it should be.

CompanyTickerNet Debt/EBITDAYTD Ttl. Rtn. (%)P/E (TTM)Fwd P/E
Acuity Brands Inc.AYI-N1.06-45.889.5710.38
Alphabet Inc. Cl AGOOGL-Q0.320.6728.1525.04
Cognizant Tech Solutions-ACTSH-Q0.13-19.9613.7814.67
F5 Networks Inc.FFIV-Q0.79-1.8819.1815.45
Humana Inc.HUM-N1.303.1821.6820.05
Intuit Inc.INTU-Q0.436.2444.7837.85
Microsoft Corp.MSFT-Q1.7214.2931.7330.25
Monster Beverage Corp.MNST-Q0.012.5531.4230.61
Regeneron PharmaceuticalsREGN-Q0.9353.7024.5721.13
Synopsys Inc.SNPS-Q1.4712.2144.5928.21

Source: Credit Suisse, Bloomberg 

The chart represents one narrow perspective on market action, and it’s a shortcut at that, even if real yields have successfully projected the course of the S&P 500 lately. Mr. Garthwaite’s market forecasts include many other factors that will limit the upside for equities in the short term. Specifically, he notes the high valuations for the technology stocks that currently dominate the S&P 500 raise the odds of an overall market correction in the next six months.

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Eventually, however, he believes that real yields will reach sharply negative territory at minus 2 per cent. The strategist expects that these low yields will create an equity bubble centred in growth stocks that will drive the S&P 500 P/E ratios of between 45 and 60 times, similar to the peak of the tech bubble and the “Nifty Fifty” rally of the early 1970s.

Helpfully, Mr. Garthwaite also identified a number of stocks representing high quality balance sheets and high growth that he expects will benefit most after the correction ends. The list in the accompanying table includes Alphabet Inc., F5 Networks Inc., Microsoft Corp. and Monster Beverage Corp.

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