Sensex Earnings Yield Vs Gov. Bond Yield

Earnings Yield as per investopedia is defined as The earnings per share for the most recent 12-month period divided by the current market price per share. Under the same logic, earnings yield for Sensex will be the present value of Sensex divided by last 12 months EPS or we can be more forward looking and take the coming 12 months consensus EPS estimate.

Presently this earnings yield figure for our Sensex Index is around 5.9%. The yield on India's 10 year risk free bond is around 6.5%.

Classical theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as T-bills) in their earnings yield to compensate them for the higher risk of owning stocks over bonds and other asset classes. So here we have an amazing case where a risk free asset is yielding much more than a high risk asset. The best arbitrage is to short the Sensex and go long in the risk free bond until this spread becomes acceptable.

The reverse was precisely the case around 3-4 months back when the yield on Indian government bonds was just 5% and the Sensex earnings Yield was around 9.5%. That time also the spread was over valued. So the strategy global fund managers adopted was to short Indian bonds and long sensex. Due to shorting of bonds the Yield started increasing (Bond yield and prices go in opposite direction) and as sensex moved up the yield started coming down. But this spread was taken well above the justified levels.

Thus , we can accept the spread to again become acceptable and the only way this can happen is by sensex at the levels of around 12000, if no surprising changes happen on the bonds front.

The graph above clearly shows that the long term spread between S&P500 yield and 10 year US government bold yield have being fairly consistent and any deviations have led to the movement so that the spread converges.

This what investopedia also says regarding the same:

"Money managers often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may considered undervalued relative to bonds "