Markets have run up in anticipation. In the bond market, there is expectation of rate cut by the RBI in view of soft inflation.

At the current juncture, both the market segments i.e. equity and debt, look a little stretched. In equity market, it is the valuation as represented by the conventional parameter of PE ratio, denoting the number of years for which the buyer is paying for one year’s earnings of the company. In debt, it is the yield level of the bond. The reason why valuation looks little stretched have already been discussed in various forums.

Just to recap: the PE ratio (at approx 25) is high as per historical standards, which means Nifty stocks are not cheap to buy. Coming to bonds, the yield on the 10-year government security is at approximately 6.45 percent and the overnight interest rate, represented by the RBI repo rate, is at 6.25 percent. It means there is a spread of only 20 basis points between overnight and 10-years. As per the theory of time value of money, I should get compensated for sparing for a long period of 10 years instead of just one day. Though there is no formula to define what should be the ideal spread for time value of money, approx 20 bps for 10 years looks inadequate.

So, what is happening? Markets have run up in anticipation. In the bond market, there is expectation of a rate cut by the RBI in view of soft inflation. From that perspective, bond valuation is not as stretched. RBI’s projection of CPI inflation is 2.5 percent to 3.5 percent in the first half of the financial year and 3.5 percent to 4.5 percent in the second half. Taking inflation at a ballpark of 4 percent, which is RBI’s central target in the zone of 4 percent +/- 2 percent, and 1-year T-Bill yield being around 6.38 percent, there is significant real positive yield. In the equity market, investors are building in earnings growth pick-up, higher expansion of the economy and probably a PE rerating.

There is a thumb rule to figure out the relative attractiveness between the two markets. The inverse of the 10-year bond yield is compared with the equity PE. Inverse of 6.5 percent is 15.4, which denotes that if the equity PE is at or less than 16, equity is very attractive. Now that equity PE is at approx 25, it is not as cheap. However, as discussed, the equity market may witness a PE rerating driven by lower cost of capital and better earnings growth. Since there is a discounting of future growth in equities, which is not the case with bonds, some premium is justified. However, the current gap between 16 and 25 seems to be on the higher side.

What do the valuations mean for investors? Allocation should be guided by the proven parameters of risk-return profile and horizon. Current market valuation can influence the allocation at the margin but should not be a major criterion as timing the market may not yield much over the long term. In case the equity valuation looks stretched, leave it to managers who have a proven track record of identifying value stocks, and invest with a long horizon. In the fixed income segment, if you are not aiming to benefit from the last rate cut by the RBI, you may go for conservatism and put your money in short-term bond funds instead of long term ones, to minimize volatility as and when it comes. It has been proven that over the long horizon, the outperformance of long bond funds over short term funds is not much. From 2001 till date, cumulative return from income funds is 8.04 percent and that from short term bond funds is 7.73 percent (source Crisil – AMFI Report June ’17) i.e. the outperformance is only 31 basis points.

Another perspective, for deployment of incremental flows of investors, could be alternate avenues like structured products (market-linked debentures), where the downside in case equity markets don’t give returns is protected but the market-linked coupon provides the equity upside. This is suitable for investors who want to participate in the equity market upside but are wary of the downside. However, there is a minimum ticket size required for structured debentures and is available to HNIs, not retail investors. In the mutual fund space, there are certain funds that do the asset allocation as per valuation levels in the market and restructure the portfolio at periodic intervals.

Source: https://www.moneycontrol.com/news/opinion/relative-valuation-of-equity-and-debt-what-the-market-is-telling-you-2330609.html