The valuation multiple (price-to-earnings) expands and stock prices rise when bond yields decline, and the cycle is reversed when yields rise.
For example, the S&P500 P/E multiple, on a trailing 12-month basis, had fallen to as low as 7x in the early 1982s, after US bond yields spiked in the late 1970s and early 1980s. Conversely, the index valuation expanded as bond yields began a long-term decline in yields from the record high of 15.8 per cent reached in June 1982. The resulting re-rating on equity valuation created one of the longest bull-run in the US history that finally ended with the dot-com crash in 2000.
The S&P500 rallied from a level of 112, beginning 1982, to its peak of 1,500 in March 2000 — largely led by a steady rise in the underlying earnings multiple.
The index’s P/E multiple expanded by around 2,100 basis points (bps), while bond yields were down 800 bps during the period. One bp is one-hundredth of a per cent.
The current rally in global equities was also fueled by a steady fall in bond yields that declined from a high of 4 per cent in mid-2008 to record lows of 1.5 per cent in mid-2016. In the same period, the S&P500 (earnings) multiple expanded from 14x to around 22x, and accounted for nearly half of the incremental gains in the index during the period, with the balance coming from rise in corporate earnings. The index peaked at 2,914 early last month, up 3.7x from the bottom of the post-Lehman crisis period.
Analysts are not surprised. “Higher bond yields mean higher returns for investors on risk-free assets — government bonds. This reduces the attractiveness of risky assets, unless compensated by faster earnings growth," says Dhananjay Sinha, head (research) at Emkay Global Financial Services.
US-based firms have reported double-digit earnings growth in the last five quarters, but earnings outlook has turned bearish due to the negative fall-out of the US-China trade war and burden of steadily rising interest rates.
Analysts expect further rise in bond yields in the US, putting pressure on equity valuations and stock prices. “Bond yields could rise further in the US as the Federal Reserve raises its policy interest rates, and the spike in US Fiscal deficits raises the supply of bonds," says G Chokkalingam, Founder and Managing Director of Equinomics Research & Advisory Services.
This will lead to a re-pricing of equity as an asset class, and to a further fall in stock prices in the US.
However, he sees only limited downside for Indian markets from the current levels. “Bulk of the re-pricing has already happened in India, and I see a weak correlation between India and global markets ahead,” says Chokkalingam.
The benchmark Sensex is currently trading at 22x its trailing earnings per share, down from a high of 25x in August but higher than 16.5x during the last major correction in 2013.
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