Stock market: Trends in bond market may force KSE into correction
Financial pundits say equity market to take a dip in view of interest rate hike.
The last time when the ten-year PIB yield was 2% higher than the KASB Universe’s earnings yield (February 2011), the KSE-100 Index fell 9% in the next 10 months. PHOTO: FILE
KARACHI:
Contrary to what financial pundits would have you believe, the stock market has yet to price in the unexpected increase of 50 basis points (bps) in the monetary policy rate announced last week.
Taking a cue from changing yields in the bond market, analysts believe the stock market is most likely to take a dip in view of the expected monetary tightening in the months ahead.
The ten-year Pakistan Investment Bonds (PIB) yield now stands at 12.4%, which is 150bps higher than its July 1 level, according to Farrukh Khan, an analyst covering the bond market at KASB Securities.
“The bond market has made a much quicker adjustment to changing inflation expectations,” he wrote in a research note on Wednesday, emphasising that the equity market is yet to price in the risk of further monetary tightening.
Making the monetary policy announcement on September 13, State Bank Governor Yaseen Anwar told journalists that the central bank expects inflation in the fiscal year 2013-14 to be in the range of 11%-12%. This was in contrast to the government’s earlier prediction that inflation was expected to remain around 8% in the current fiscal year.
In other words, inflation is going to be higher than the capital market’s earlier expectation, which will push the central bank towards further monetary tightening in order to steer clear of a negative real interest rate in the economy.
Now that we know the bond yields have gone up considerably in recent weeks, how exactly do we find out if the stock market is indeed overvalued relative to the bond market? Moreover, is the stock market headed for a downturn in coming weeks to price in the increase in the key interest rate?
Usually, analysts compare the ten-year bond yields with the ‘earnings yield’ of a set of stocks to determine whether they are under- or over-valued. Inverse of the price to earnings ratio (P/E), earnings yield is arrived at by dividing the EPS by the current share price of a stock.
In simple terms, earnings yield represents the percentage of each rupee invested in a particular stock that was earned by that company.
Hence, if the earnings yield for a certain set of stocks is less than the ten-year bond yield, one can deduce that these stocks are overvalued. And this is precisely what has happened to leading stocks on the Karachi Stock Exchange of late.
“The earnings yield of the KASB Universe is currently 10.4% compared to the ten-year PIB yield of 12.4%,” Khan said, while referring to the range of stocks that his brokerage house covers.
According to another Karachi-based brokerage house, Global Securities, valuations of companies on its coverage radar have gone down by 1-6% on average due to the 50 bps hike in the risk-free interest rate.
Leveraged companies in textile, cement and fertiliser sectors can see earnings attrition due to the higher discount rate, Global Securities said in a separate research note issued to its clients on Wednesday.
The current spread differential of 2% between the ten-year PIB yield and the earnings yield of companies on the coverage radar of KASB Securities should be alarming for investors. After all, stock market investors ought to have an earnings yield, which is over and above the bond market yield, given the many risks inherent in the equity market.
“As fixed income becomes more attractive than equities, the stock market is likely to underperform,” Khan noted.
So be warned, small investor. Last time the ten-year PIB yield was 2% higher than the KASB Universe’s earnings yield (February 2011), the KSE-100 Index fell 9% in the next 10 months.
Published in The Express Tribune, September 20th, 2013.
Contrary to what financial pundits would have you believe, the stock market has yet to price in the unexpected increase of 50 basis points (bps) in the monetary policy rate announced last week.
Taking a cue from changing yields in the bond market, analysts believe the stock market is most likely to take a dip in view of the expected monetary tightening in the months ahead.
The ten-year Pakistan Investment Bonds (PIB) yield now stands at 12.4%, which is 150bps higher than its July 1 level, according to Farrukh Khan, an analyst covering the bond market at KASB Securities.
“The bond market has made a much quicker adjustment to changing inflation expectations,” he wrote in a research note on Wednesday, emphasising that the equity market is yet to price in the risk of further monetary tightening.
Making the monetary policy announcement on September 13, State Bank Governor Yaseen Anwar told journalists that the central bank expects inflation in the fiscal year 2013-14 to be in the range of 11%-12%. This was in contrast to the government’s earlier prediction that inflation was expected to remain around 8% in the current fiscal year.
In other words, inflation is going to be higher than the capital market’s earlier expectation, which will push the central bank towards further monetary tightening in order to steer clear of a negative real interest rate in the economy.
Now that we know the bond yields have gone up considerably in recent weeks, how exactly do we find out if the stock market is indeed overvalued relative to the bond market? Moreover, is the stock market headed for a downturn in coming weeks to price in the increase in the key interest rate?
Usually, analysts compare the ten-year bond yields with the ‘earnings yield’ of a set of stocks to determine whether they are under- or over-valued. Inverse of the price to earnings ratio (P/E), earnings yield is arrived at by dividing the EPS by the current share price of a stock.
In simple terms, earnings yield represents the percentage of each rupee invested in a particular stock that was earned by that company.
Hence, if the earnings yield for a certain set of stocks is less than the ten-year bond yield, one can deduce that these stocks are overvalued. And this is precisely what has happened to leading stocks on the Karachi Stock Exchange of late.
“The earnings yield of the KASB Universe is currently 10.4% compared to the ten-year PIB yield of 12.4%,” Khan said, while referring to the range of stocks that his brokerage house covers.
According to another Karachi-based brokerage house, Global Securities, valuations of companies on its coverage radar have gone down by 1-6% on average due to the 50 bps hike in the risk-free interest rate.
Leveraged companies in textile, cement and fertiliser sectors can see earnings attrition due to the higher discount rate, Global Securities said in a separate research note issued to its clients on Wednesday.
The current spread differential of 2% between the ten-year PIB yield and the earnings yield of companies on the coverage radar of KASB Securities should be alarming for investors. After all, stock market investors ought to have an earnings yield, which is over and above the bond market yield, given the many risks inherent in the equity market.
“As fixed income becomes more attractive than equities, the stock market is likely to underperform,” Khan noted.
So be warned, small investor. Last time the ten-year PIB yield was 2% higher than the KASB Universe’s earnings yield (February 2011), the KSE-100 Index fell 9% in the next 10 months.
Published in The Express Tribune, September 20th, 2013.