Weekly Newsletter #10/2015

Share this post

In our last newsletter you read about the challenges that investors looking for yield are facing these days. Since major government yields have fallen to nearly zero or even below we suggested to invest in very conservative equity-linked structured products as fixed-income substitute. And what about more dynamic equity linked products such as the Lock-In product below? Well, many investors argue that equity markets have become too expensive after recent big gains – particularly U.S. equities. Is this true?

The answer is – guess what? – not easy. Let’s take the S&P500 index which covers the 500 largest U.S. companies. It gained 78% during the last 10 years or about 8% p.a. Is it expensive now? Most valuation models discount future cash flow by a factor that is composed of risk free yield plus risk premium. This factor is very sensitive to marginal changes and opinions in a fair risk premium vary widely among economists. However, historically low yields are a matter of fact. Thus historic valuations – e.g. P/E of 10 is fair and P/E of 20 is expensive – cannot work.

Let’s take a closer look how yields have changes. 10-year US Treasury yields have come down from about 7% to recently 2.0% – see chart of the day below. The earnings yields (= 1 / PE ratio) of S&P500 varied between 4% and 9%, recently yielding 5.3%. If you consider the continuous fall of treasury yield you would expect earnings yields to fall too. Otherwise risk premiums must have risen or equity markets got cheaper versus 10 or even 20 years before! Now you can decide yourself if the world has become more dangerous or equity markets cheaper! In Erwin Lasshofer’s opinion equities are still far from (too) expensive.