The sell-off in the bond market and rising equity valuation have pushed the spread between the yield on 10-year government bond and Nifty’s dividend yield to a four-year high level.
The sell-off in the bond market and rising equity valuation have pushed the spread between the yield on 10-year government bond and Nifty’s dividend yield to a four-year high level. The spread between these two gauges climbed to nearly 7% on Wednesday — its highest level since October 2014. This essentially signifies that equities are becoming more and more expensive than bonds. The broader Nifty, which has gained close to 8% since the beginning of the year, has been trading at an average earnings multiple of 17.6 in 2018. The index had fallen as much as 9.2% in ten months after the spread hit 7% last time in 2014.
At Wednesday’s close of 11,369.9, the benchmark Nifty trades at a price-to-earnings multiple of 18.08 to the estimated one-year forward earnings. This is a premium of 12.7% to the long-term average price-to-earnings multiple of 16.01. This compares with 8.6 times for Kospi and 13.6 times for Jakarta Composite. Brazilian Bovespa and the Shanghai Composite are trading at a price-to-earnings multiple of 9.9 and 9.8 respectively, data from Bloomberg showed. Indian equities continue to command such a premium despite actual earnings per share (EPS) coming in much lower than what analysts estimate at the beginning of the year for the last several years.
Blended 12-month forward estimates for the Nifty at the beginning of 2017, for instance, was Rs 535.91, while the index ended the year with an EPS of just Rs 465.28. This essentially meant that while analysts estimated Nifty’ EPS to grow by 33.4% at the beginning of 2017, the index actually ended the year registering an EPS growth of 15.8%, which is less than half what analysts had predicted. And 2016 was not an aberration. In 2016, the gauge’s profit grew by 4.8% against analysts’ estimates of 34.2%.
The yield on the benchmark bond settled at 8.13%, after hitting an intra-day high of 8.23% on Wednesday whereas dividend yield for the Nifty, which closed at 11,369.9, stands at 1.18%. The spread between the benchmark 10-year yield and the Nifty dividend yield is given significant consideration by money managers when they allocate their funds between equity and debt, given the risk-free nature of sovereign bonds. Market participants observe, the earnings have to catch up, and the growth will have to be strong to justify the optimism shown by the rising valuations.