VR Logo

The Chartist: Drive Slow

Investors have bet on fast EPS growth since 2003 & ignored rising yields. Lower EPS growth in 07-08 could mean a big drop in prices

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 2,059 points. By March 2005, the Nifty had risen to 2,150 but the PE was down to 15.5.

Expectations of fast EPS growth can cause a breakdown in the inverse relationship. If EPS growth expectations are high, the PE can rise even alongside rising debt yields. This combo of rising yields and rising share prices is dangerous. If the risk premium goes negative, a small change in growth expectations can lead to a big crash in equity prices.

The Indian stock market is seeing precisely this dangerous combination at present. Investors have bet heavily on fast EPS growth since 2003 and ignored rising yields. Lower EPS growth in 2007-08 could mean a big drop in prices.

Let's see how the situation developed through a few snapshots: Since India doesn't have a developed secondary market in bonds, the 364-Day Treasury Bill may be used as a proxy. The RBI holds fortnightly auctions; the T-Bill's yield-to-maturity (YTM) is risk-free; YTM changes to reflect rate expectations. In the attached chart Equity Risk Premium, the YTM has been mapped versus the E-Yield so we can visualise the swing from a positive risk premium (a 'buy') to a negative risk premium (a 'sell'). In June 2003, the 364 T-Bill auctioned at YTM of 4.95 per cent. The Nifty was then at 1,045 points and the Nifty's average PE was 12, with an implied E-Yield of about 8.4 per cent. That was a buy on very conservative valuations since the risk premium was large.

By June 2004, the T-Bill YTM was 4.6 percent, the Nifty was at 1,550 with a PE of 12.5 and an E-Yield of 8.02 per cent. Still a very comfortable risk premium.

By June 2005, the YTM hit 5.6 per cent. The Nifty was at 2,112 with a PE of 14 and an E-yield of 7.1 per cent. The risk premium was less but still in favour of the equity market.

By June 2006, the T-Bill YTM was over 7 per cent, the Nifty was at 2,923 and the PE was 16.6 with an E-Yield of 6.02 per cent. The risk premium has turned negative. Actually this happened in late December 2005 when the Nifty was in the range of 2,800-2,900 with an associated E-yield of 5.8 versus an YTM of 6.1. Through the whole of calendar 2006 the stock market has been in an 'amber/ red zone'. By January 17, 2007 when the most recent auction took place, the T-Bill's YTM had risen to 7.27 per cent. The Nifty was at 4090 with a PE of 21.4 and an E-Yield of 4.67 per cent. The alarmingly large negative risk premium means that the equity market is now exceedingly overvalued in an earnings discount model.

Let's look at current expectations. Rate expectations are uppish. The RBI is expected to hike the bank rate/repo rate soon, given higher inflation numbers. EPS expectations continue to be high - the 2006-07 third quarter results have been excellent.

Between 2003 (rates bottomed in late 2003) and now, rates have risen by almost 300 basis points from an YTM low of around 4.3 to current levels of 7.27. EPS rose by around 114 per cent (absolute) between March 2003 and March 2006. That's a compounded rate of 28 per cent EPS growth and it may be exceeded this year.

If that CAGR is maintained into 2007-08, the forward PE of the Nifty is about 16.6 and the implied 'forward' E-yield is about 6 per cent. The risk premium is still negative! The Nifty's EPS would have to grow, may be 60 per cent, to develop a positive risk premium that matches current YTMs and, YTMs are likely to rise.

What happens if EPS growth is lower than expectations in 2007-08? A PE of 14 is just about sustainable at an YTM of 7.5 per cent. A 33-35 per cent drop in valuation will translate into lower capital loss (20-25 per cent perhaps) given that EPS will grow by some amount at least. But a big loss is nevertheless a big possibility in 2007-08.