Image: Danish Siddiqui/ Reuters
The BSE Sensex closed at 32,037.38, 232.56 points up, a record, while the National Stock Exchange Nifty 50 closed up by 75.60 points at 9,891.70 on Thursday. In the early trading session, the markets rallied with the hope that the Reserve Bank of India (RBI) would cut interest rates in the August 2 monetary policy outing. The 30-share index has rallied 2,000 points in just over two months since it first crossed the 30,000-level on April 26 this year. Investors flocked to the markets on Thursday, confident that this time, the Monetary Policy Committee had no reason not to cut rates since retail inflation had also dropped to 1.54 percent in June from 2.2 percent in May, according to data released by the government. Meanwhile, industrial activity indicated by IIP also shrunk in May. "A slew of macro-economic data at home and positive comments by the Federal Reserve chairwoman, Janet Yellen on future rate increases in the US, (also) spurred the 'risk-on' sentiment in the market," Karthikraj Lakshmanan, Senior Fund Manager - Equities, BNP Paribas Mutual Fund said. Investors are happy. There is now a feeling that the market rally is sustainable for some time to come. “Frankly, it is difficult to understand why the market is so euphoric. It is already high at a historical P/E of 23.5. This is exactly the time when investors should ideally stay away from the market but sadly many investors might just take it as a cue to get into the market,” said a fund manager.
The earnings yield of the market is at a 4.24 percent compared to the 10 year bond yields, which are at 6.45 percent. Generally, a higher earnings yield means equity market is attractive. The earnings yield is the inverse to the P/E ratio. The number is generally compared to the long-term bond yields to understand if the stock markets are overvalued
Right now, the earnings yield is low compared to bond yield. In an ideal situation, the equity market should provide a risk premium over bond yields to compensate for the extra risks that investors are taking. Bonds, in general, are considered risk-free.
But the equity markets are discounting this expecting a rate cut. In a span of over six months, the market has moved from a rate hike expectation to a rate cut expectation. The last rate cut happened in October 2016. Since then, the sentiment of the market has been low on account of demonetization where many analysts expected a slowdown in the GDP growth rate. There was a slowdown in the real GDP growth rate at 6.1 percent in the fourth quarter of 2016-17. Now there is an expectation that India will clock a GDP growth rate of 6.9 percent for FY17.
“There is a case for a rate cut and bond markets have rallied on that basis. Especially after the June policy bond yields are down by 25 basis point. This is indicative of the fact that the market has gone into a rate cut expectation”, says R Sivakumar, head – Fixed income, Axis Mutual Fund.