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Following a more than 15 per cent surge in the National Stock Exchange (NSE) Nifty 50 from this year’s lows, the spread between the 10-year government security (G-sec) and the Nifty earnings has approached the danger zone of 2 percentage points (ppt).
At present, the G-sec yield is roughly 7.09 per cent, while the Nifty earnings are 5.12 per cent.
As a result, the spread works out to 1.98 ppt, ever so slightly below the danger mark of 2 ppt.
A recent analysis by CLSA shows that “most of Nifty’s tops have been at the 2-ppt bond yield-equity yield level”.
The brokerage analysed equity returns whenever the yield spread moved past 1.5 ppt.
The study showed that the Nifty delivered muted returns on a one- and two-year time frame whenever the bond yield/equity yield was above 1.5 ppt.
In the past, the market has generated the best returns whenever equity yields have been greater than bond yields.
Typically, the yield on the benchmark G-sec— also called the risk-free rate — is the threshold for equity returns.
The rationale is that the reward for investing in a risky asset like equities should be higher than that offered by a risk-free sovereign bond.
If a company’s earnings yield (the inverse of the price-to-earnings, or P/E, ratio) is higher than the bond yield, it indicates that the profit generation is attractive vis-à-vis the yield on offer on a fixed income.
Currently, the estimated 12-month forward earnings per share for the Nifty50 is about Rs. 1,000, while the index last closed at 19,565.
The 12-month forward P/E ratio is 19.56x, and the earnings yield (1 divided by 19.56) is about 5.12 per cent.
