Earnings yield of Sensex cos only 110 bps higher than same on US govt bond

A persistence rise in yields on the 10-year government bond in the US and India over the last 12 months was steadily turning the risk-reward ratio against Indian equities, making a market correction inevitable, according to analysts.

At their current levels, Sensex companies, on average, offer earnings yield of 4.3 per cent, just 110 basis points higher than the current yield on 10-year US government bond — the world’s most popular and liquid risk-free asset class. The spread is lowest in eight years and nearly half of the 20-year average spread of 212 basis points. 

This, the analysts say, has made Indian equities financially unattractive for foreign investors, leading to a sell-off by foreign portfolio investors (FPIs). “The latest correction in the market is not surprising, given the price-to-earnings multiples and spread of earnings yield over risk-free returns (bond yield) in the broader market, are now closer to the levels last seen during the 2000 dot-com bubble,” says Dhananjay Sinha, head (research) at Emkay Global Financial Services.

Earnings yield is calculated by dividing a firm’s latest trailing 12 months (TTM) net profits by its market capitalisation, and shows the potential yield for an investor if the firm distributes its entire annual profit as equity dividends. As bond yield is income on a risk-free asset, a higher yield reduces the attractiveness of equity, which comprises risky assets, and vice versa.

Analysts say that equity investors, especially FPIs, expect companies to offer significantly higher yields (on their earnings) than the one offered by risk-free assets (US government bond) to compensate for the risk involved in equity investments.

FPIs have cumulatively sold $2.2 billion worth of Indian shares in 2018. With a cumulative investment of nearly $400 billion in the last 20 years, FPIs are the largest non-promoter investors in listed stocks in India.

Indian investors, in contrast, have mostly operated on negative spreads except for between August 2002 and August 2004, and again between October 2008 and April 2009. At its current valuation, the earnings yield on Sensex firms is nearly 390 basis points lower than the yield on 10-year government bonds, a level last seen in December 2007 on the eve of the January 2008 correction.

Bond yields in the US are up 81 bps since the beginning of the calendar year, while they have risen 85 bps in India during the period. In the same period, earnings yield for index companies has risen 35 bps, largely due to moderation in the P/E multiple, which is now down to 23.2x trailing earnings per share of index companies, against 25.2x at the beginning of 2018. 

Analysts say the rise in bond yields has translated into drying up of liquidity on Dalal Street, which has kept the market on an upward trajectory despite below-par earnings growth, in the last few quarters. The headwinds came from the foreign currency market, where the rupee has lost nearly 14 per cent of its value against the dollar. 

"The equity valuations were getting stretched, making the market vulnerable to a sell-off at the first macroeconomic instability," says G Chokkalingam, founder and MD of Equinomics Research & Advisory Services. 

"Currency depreciation directly cuts into foreign investors' returns, further reducing the attractiveness of the Indian markets for them," he adds. 

The fall in rupee is also likely to hit corporate earnings for the majority of companies, magnifying the impact of tighter liquidity after the recent rise in bond yields. 

"In the context of a likely earnings downgrade, we believe market multiples will be at risk due to the fading liquidity scenario. We see tapering of liquidity emanating from both portfolio flows of FIIs and mutual funds," wrote Sinha in his recent report on the Indian equity market.

He sees more pain for the broader market, especially in the mid- and small-cap space, given their still-rich valuations. "Even after the nearly 20 per cent decline in the mid-cap index, the trailing P/E at 35x in September 2018 is still at a 50 per cent premium to the benchmark indices. The risk is that it can go back to an average discount of 12-15 per cent, instead of a premium, as it existed prior to May 2014," he wrote.

Analysts expect more pain unless the rupee stabilises in the foreign currency market, or if companies report strong double-digit earnings growth in the forthcoming quarters that negates the impact of currency depreciation for FPIs.