Even though the benchmark indices have sustained a discount to their long-term averages after briefly converging in early November 2012, equities still look less attractive or overvalued when compared with bond yields.
However, market experts believe that an imminent improvement in the earnings cycle in the next two quarters and a further reduction in the benchmark interest rates may change the situation in the coming months.
Based on the expected earnings of the Sensex companies for 2013-14, the earnings yield — calculated by dividing the earnings per share by the index\'s current value — at 7.4%, still maintains a discount to 10-year bond yield, which is close to 7.8%.
At the current levels, while the bond yields are in line with their long-term averages, the earnings yield is trading a tad above its average value of 7.25% of the last seven years.
“As interest rates are cut, this equation would change. Further, retail participation in equities, which has remained muted with consistent redemptions in 2012, may also get a boost from the government\'s additional measures. Both these developments would play out post-Budget, resulting in a reversal in this trend,” said Rakesh Arora, managing director and head of research, Macquarie Capital Securities.
Generally, the asset allocation between equity and bonds is based on how earnings yield compete against that of the benchmark bonds.
In early 2003-2005 and late 2008, a higher earnings yield was followed by a strong rally in the equities. Interestingly, for most part of the last three years, bond yields have maintained an edge over the earnings yield.
However, experts also point out that the correlation between the bond and equity markets of India differs substantially than their global standings where the 30-year-long bull run in the bond market is expected to end with a substantial outflow making its way to equities.
“The Indian debt market is driven by institutional participation, unlike equities, where retail investors are generally seen giving higher allocations,” said Mahendra Jajoo, ED and CIO-fixed income with Pramerica Mutual Fund.
As per Laxmi Iyer, head of fixed income with Kotak Mutual Fund, unlike the global scenario wherein the switch between the equity and bond market rides on the ‘risk-on’ or ‘risk-off’ mode, in India, both markets have lower negative correlation.
“While the 10-year benchmark is seen sliding down towards 7.5% towards the later part of 2013, a more conclusive bottoming out of the Indian equity market may lead to some money moving towards equities,” added Iyer.