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Increasing Divergence Between Bond Yields and Earnings Yield
Jan 11, 2018


Previously, we wrote about the market capitalization to GDP ratio. This ratio indicated valuations reaching its peak levels. There is one more ratio, which is an important indicator for equity markets. The earnings yield vis-a-vis 10-year bond yield.

Earnings yield is calculated as the net profit for the trailing 12-month period, divided by market capitalization (inverse of PE Ratio).

A high earnings yield indicates that the market is assuming a lower growth in profits in the future for the company.

A low earnings yield indicates that the company is expected to have high profit growth for an extended period of time.

This ratio can be used to evaluate the valuations and compare how cheap or expensive the stock market is relative to the debt market. A comparison of the yield between the two capital instruments, equity and debt, can be used to assess the risk-reward for investing.

This tool has been a very important indicator to identify the bottom of the equity market. Whenever the earnings yield has crossed bond yields, it implies that even assuming nil earnings growth in perpetuity equity will deliver better returns than debt. Similarly, when equity yields are lower than bond yields, it indicates that equities are expensive than bonds.

From the data revealed in the chart above, we can observe that lately the divergence between bond yields and earnings yield has increased. This means equity markets have become expensive. The sharp rally was due to huge inflows from domestic institutional investors (DIIs) and foreign institutional investors (FIIs). Also, compared to equity, debt has become significantly cheaper.

Increasing divergence is unsustainable and earnings yield should rise driven by an increase in corporate earnings. Otherwise, the correction could be on the cards.

Data Source: Bloomberg, investing.com

This Chart Of The Day was published in The 5 Minute WrapUp - Will Bitcoins Put Paper Money to Shame?

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