Does narrowing earnings yield spread hint it's time to buy?

ET INTELLIGENCE GROUP: Indian equities are looking attractive going by the current spread between the Sensex earnings yield and the yield of the 10-year treasury bonds. The earnings yield spread of the Sensex relative to the treasury yield is narrowest in five months following a 7 per cent drop in the Sensex in a month.

The earnings yield is defined as inverse of the price-earnings ratio. In theory, if the earnings yield is higher, stocks may be considered undervalued relative to bonds.

The trailing earnings yield is 4.94 per cent while the bond yield is 7.77 per cent. The difference between them has dropped to 284 basis points, which is lowest since March 2015, according to the data from Bloomberg.




Historically, the equity market falls bottomed out whenever the gap between the two yields dropped to 254 basis points signaling the stocks were cheaper relative to bonds.

Suppose an investor with certain risk appetite is trying to decide between a stock with earnings yield of 10 per cent and a fixed income instrument with 6 per cent yield. Using the yield spread helps in deciding whether the yield differential of 4 per cent justifies the risk of investing in the stock. Even if the stock will have dividend yield too, usually the investor is more concerned about the total potential return than actual return.

"The more the reduction in the gap between the earnings yield and the bond yield, the more compelling is the reason to invest in equities. It offers an attractive risk-reward matrix to enter the market," said Prakash Diwan, director at Altamount Capital.

However, the method of yield differential to predict the relative attractiveness of the stock market has few limitations. It does not take into account the fact that company earnings often reflect the impact of inflation whereas the coupons of bonds are fixed and do not change in tandem with inflation. In addition, the bond yield is calculated by assuming that coupons are reinvested at the given yield rate while earnings yield often do not include return on reinvested dividends.