The S&P 500 gives reason for optimism

In his recent letter to investors, John Paulson stated that the most relevant indicator that they track in the current environment is the Equity Risk Premium (compiled by JP Morgan). Paulson states that the Equity Risk Premium is the highest it has been in 50 years, which indicates to him that equities will rise further to close the gap with bonds.

The JP Morgan data shows that the Equity Risk Premium has only exceeded 5% on five occasions since 1957, these years being 1958, 1974-75, 2009-10.

Of course the Equity Risk Premium can always be closed by bond yields rising rather than equity yields falling. However, for the time being that is probably not a likely scenario and that is why Paulson is enthusiastic about equities.

Paulson states that he believes growth will continue and will accelerate and that this is the part of the cycle where they want to have long event exposure and do not want to be under-invested.

I note that Robert Shiller (of Yale University) does not share Paulson’s optimistic view and is more or less forecasting anemic growth for the S&P 500. While I have a lot of respect for Shiller, I think he is more likely to be wrong than right. I’m not saying that I expect spectacular growth to occur – I don’t, but nor do I expect anemic growth.

An added dimension for those of us who live in countries with very strong currencies, is the play on the $US by going long US equities. For example, the Australian dollar ($A) is a highly volatile currency that has on average traded at around $US0.73 throughout its 27 year history as a free floating currency. Now the $A is trading at around parity (or more) with the $US.

Australia is highly dependent on commodity prices (largely iron ore and coal), has an under-performing anti-business federal Labor government in power and a grossly inflated housing market. These are not factors which would inspire enormous amounts of confidence in the $A staying at parity or above with the $US.

I don’t want to sound overly pessimistic, but economic conditions in Australia will not get much better than they have been in recent times – the risk is very much to the downside. The reverse is true for the US.

It has also largely gone unnoticed (by those outside Australia) that the Reserve Bank of Australia has been pushing out potential interest rate rises further and further into the future. Those foreign funds holding the $A would have predicated their investments on a current cash rate of approximately 50 basis points more than it actually now is. In other words, they are getting “suckered” into holding $A for much longer than they initially intended.

The US is slowly emerging from a very serious recession, there is cause for optimism. And I don’t mind at all having an exposure to the S&P 500 especially when I can buy that exposure with an $A that is worth more than the $US.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).