The Chartist: Drive Slow

The relationship between bonds and equity is fundamental. Debt offers risk-free returns. Any financial instrument, which carries risk, must offer a premium to debt returns. Therefore, there is an inverse relationship between bond yields and equity valuations. The simplest explanation of the above is to use an earnings discount model of equity valuation, which assumes equity returns are equal to earnings per share (EPS). An earnings yield (E-Yield) turns the PE ratio upside down and expresses EPS as a percentage of the share price. Now, the E-Yield should be at premium to debt yields given higher equity risk. If the bond yield is low, the E-Yield may be low, and conversely the PE may be high. If the bond yield is high, the E-Yield must be high and hence, PE must be low. A lower PE doesn't always mean lower share price. If EPS grows quickly, price may rise even as PE falls. For example, in December 2004, the Nifty PE was at 17 with the index level at

This article was originally published on February 01, 2007.