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Has the Market Bottomed Out?

Jun 11, 2018

Madhu Gupta

The stock market is like a swinging pendulum.

But unlike a pendulum, it's very difficult to predict how the market will swing.

The Indian markets remain volatile. After shedding 10% from peak value in 2018, the BSE Sensex recovered nearly 8.8%.

But uncertainties over the global trade relations and expectations of faster rate hikes by the US Fed are the short-term headwinds.

Is there a more rational measure to study the direction of the market?

Yes, there is.

It's the yield-spread or the gap between the risk-free return and the earnings yield.

The risk-free return is the return guaranteed on a safe asset such as a 10-year government bond that enjoys sovereign backing. This asset has literally zero risk of default. The return earned on it is known as the sovereign bond yield.

In comparison, the earnings yield (i.e. the ratio of net profit to market capitalisation) is far riskier and volatile. It is not guaranteed and depends on the financial health of the underlying companies.

The difference between the bond yield and earnings yield is known as the yield spread.

During boom times, companies flourish, resulting in high earnings growth. This manifests in the form of higher earnings yield as compared to the bond yield. So, investments flow in to equities, rather than bonds, fueling a stock market rally. In such a scenario, the yield spread can narrow or turn negative.

But during a recession when corporate earnings take a hit, the falling earnings yield make stocks less attractive. This results in funds moving out from the stocks into bonds. In this case, the yield spread widens.

The yield spread has widened in the past few years.

Recently, the yield on the 10-year government bond crossed the 8% mark, reaching a 3-year high level. This has come on the back of a 0.25% rate hike by RBI after a gap of around four years.

As a result, the yield spread between the 10-year government bond and the BSE-500 companies has widened to 4%. This is 1.7% higher than the 10-year average yield-spread of 2.3%.

For the yield spread to revert to mean, either the risk-free bond yield needs to contract or the earnings yield needs to improve.

With hardening crude oil prices, rising fiscal slippages, and faster than expected rise in the US treasury yields, bond yields are not expected to temper down anytime soon.

Further state-owned banks, the biggest holder of bond securities, are not actively participating in the bond markets. The resulting high supply of bonds has exerted pressure on prices pushing up their yields.

What about stock returns or earnings yield then?

As India Inc continues to grapple with low capacity utilisation and sluggish investment demand, earnings are not likely to improve very soon.

So for the yield spread to narrow down, stock prices most likely will have to correct further.

Having said that, factors such as recovery in rural demand, faster resolution of bad loans in the banking system, and the government's strong focus on infrastructure are expected to spur economic growth and boost corporate earnings in the long run.

Until then, the market is likely to remain in a bear grip.

Madhu Gupta

Madhu Gupta (Research Analyst), ValuePro has a post graduate degree in both physics and finance. Having worked with India's leading economic research agency, she has a natural flair for numbers and analytics. She brings with her a near-decade long rich experience in the field of finance. A firm believer of the principles of value investing, she looks for robust businesses with durable competitive advantages.


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