Rough market weather forecast

Bond yield ratio, high inflation reason enough to expect earnings downgrade, warn analysts.

Analysts say retail investors should not get carried away by the market rally in the past two sessions, after crude oil prices eased and there was better news on Greece. They say the earnings yield is significantly below bond yield and this indicates sustained weakness ahead.

The trailing 12-month earnings yield of the Sensex is at six per cent and is currently below the 10-year bond yield, which is at 8.26 per cent. Raamdeo Agarwal, joint managing director, Motilal Oswal Financial Services, said in a rising interest rate environment, in choosing whether to put money in equities or bonds, it is important to look at these two figures. Earnings yield is the percentage of gains earned on each rupee invested in a stock and calculated by dividing the 12-month trailing EPS (earnings per share) by the current market price.

Gopal Agrawal, chief investment officer from Mirae Asset Global Investments, said investors should closely look at the gap between the two yields, for a widening one indicates the markets are not attractive. In May 2008, the earnings yield was significantly below the bond yield. The Sensex was then around 17,000 and interest rates were near their peak. In five months, the markets tanked to 8,500 levels.

KEEP IN MIND
Investors should also look at the earnings yield to bond yield ratio. For the past 10 years, it has been around one. Girish Pai, co-head, institutional equities, from Centrum Broking said if the ratio rose above 1.5, the markets would give positive returns over the next 12 months and if it falls below one, the markets are considered overvalued. He said the current earnings to bond yield ratio is 0.73, meaning a fair likelihood that markets would correct further, unless bond yields fall swiftly.

For the gap between the two yields to bridge and the markets to become deeper in value, either bond yields should fall or earnings yield should improve. Analysts said in a rising interest rate regime, the former was unlikely. Instead, there was a high possibility that the markets would correct and the earnings yield would improve.

Though the markets are trading at an attractive valuation of 15 times the one-year forward P/E (price to earnings multiple), there is a concern of earnings downgrades, as inflation continues to remain high and this may prompt the central bank to tighten further. Ajay Parmar, head of research – institutional equities, Emkay, said if earnings were going to be downgraded, the EPS would decline further to Rs 1,180 from Rs 1,240 and the P/E to rise to 17.

Investors should also look at other parameters besides earnings yield and bond yield to invest in the equity market. The earnings to bond yield gap was stark during the early part of 2010. Yet, the Sensex was still able to give 17 per cent returns, as the Reserve Bank had just begun the process of raising rates and its US counterpart had announced Quantitative Easing-II, which caused cheap money to find its way into emerging market equities, including India.

Agrawal said investors should closely look at inflation. If it comes down to 4.5 per cent, the markets will start rallying far ahead of the actual change in the interest rate regime and a drop in bond yield. Additionally, a sustained decline in crude oil prices, overseas fund flows and government reforms are other key areas to watch, which may spur a rally in the Indian equity markets.