The fol­low­ing para­graphs are excerpts from Thursday’s mar­ket mus­ings by David Rosen­berg, chief econ­o­mist and strate­gist of Gluskin Sheff & Asso­ciates in which he delib­er­ates the invest­ment merit of cor­po­rate bonds ver­sus equities.

“First, while Baa cor­po­rate spreads have nar­rowed sharply from their Armaged­don highs, at 370 basis points they are still pric­ing in a very bad eco­nomic and finan­cial mar­ket sce­nario — still wider than at any point of the 2001 or 1990 reces­sions or the 1998 LTCM/Russian debt default freeze-up. In fact, his­tory sug­gests that the cor­po­rate default rate would have to rise well above 7% for cor­po­rate bonds to deliver neg­a­tive returns with yields as high as they are at around 7¼%. In a 1¼% infla­tion rate world, this is a hefty 8½% real rate for investors to chew on. Not too shabby.

“The com­pa­ra­ble yield in the equity mar­ket, depend­ing on whether one uses reported or oper­at­ing P/E mul­ti­ples on for­ward or trail­ing earn­ings, is lit­tle bet­ter than 6½%. So cor­po­rate debt still trumps stocks. And what this 200 basis point ‘yield gap’ is telling you is that either cor­po­rate bond prices will need to rally more down the road or we need to start see­ing cor­po­rate earn­ings growth recover sharply enough to pull those mul­ti­ples down to more attrac­tive levels.

“We went back in time to see what the typ­i­cal one-year total returns for the S&P 500 when the start­ing point for the P/E mul­ti­ple is in a 10x-20x range and we get any sort of pos­i­tive earn­ings growth in the ensu­ing twelve months, and indeed that total return growth aver­ages out to be nearly +15%. This is why the val­u­a­tion is impor­tant — when the start­ing point on the mul­ti­ple is closer to 30x, you need to see at least 20% earn­ings growth in the com­ing year to gen­er­ate any pos­i­tive returns in equi­ties at all.

“Our analy­sis would seem to sug­gest, given the mul­ti­ple that coin­cided with the mar­ket trough, and under the pro­viso that we at least see some mod­er­ate pos­i­tive growth in cor­po­rate prof­its, that the March lows will hold. Our chal­lenge now is nav­i­gat­ing the fore­cast after a mas­sive 40%+ rally that has already occurred with­out any evi­dence of a mean­ing­ful earn­ings turn­around. The onus was on the bears back in March; the onus is now on the bulls.

“Our point is that the equity mar­ket has already gone beyond — by a fac­tor of three! — what is nor­mal in terms of the returns it usu­ally gen­er­ates in a given year when the start­ing point on the mul­ti­ple is low to mid teens and earn­ings are up, say, roughly 10%. In other words, there is a whole lot of good news priced into stocks at cur­rent price levels.

“From our van­tage point, a pull­back towards 800 on the S&P 500 would not only be jus­ti­fied under the prospec­tive earn­ings land­scape, but would likely also pro­vide a wel­come buy­ing opportunity.”

Source: David Rosen­berg, Gluskin Sheff & Asso­ciates — Pas­try with Dave, July 2, 2009.

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Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

Comments

One Response to “David Rosenberg: Corporate Bonds Still More Attractive Than Equities”

1. Ann Martin Says:
   July 6th, 2009 at 1:24 pm

   worth read­ing