The markets could correct by around 15 percent, if there is a mean reversion of the spread between bond yields and earnings yields, according to a Jefferies report.
In a report, titled the “Unconvincing Market Rally”, the analysts point out that the rally has taken the yield gap to “uncomfortable levels”. That is, the difference between the bond yield and earnings yield has gone up 113bps above the average. If the gap between the two yields reverts to mean, the markets could correct sharply.
Also read: Nifty to test 17,800 before the big fall: Elliott Wave analyst Rohit Srivastava
The Nifty was trading at 17,525 at closing today, which is more than 15 percent rise from its 52-week low of 15,183.
“India's 10-year G-sec rate has fallen from the recent peak of 7.62% in Jun'22 down to 7.35%. However, the market 12M fwd PE has gone up to 19.3x, driving the Bond yield - earnings yld gap up to 2.2ppts which is 113bps higher than average. A potential mean reversion would imply a c.15% correction,” they wrote.
According to them, there is almost a “Goldilocks” situation in the US–no recession and the economy holding up well despite a dovish Fed–but it is hard to maintain. Once this spell breaks, the favourable sentiment to emerging markets could recede.
Also read: Why is the market rallying when there is fear of recession?
“The US Fed has hiked its benchmark rates by 225 bps so far, but the tone on further hikes doesn’t appear that hawkish, implying that the Fed might go slower. The US 5y5y (i.e. long term) inflation expectations remain under the psychological mark of 2.5%. At the same time, the US 10- year yields have also corrected by 70bps from the recent peak to 2.8%, bringing down the risk-free rate globally, including in India. The Dollar index is also down 2% from peak, implying favourable sentiment towards emerging markets. The improving global sentiment is reflected in FPI flows into India, which is +US$2.4bn since reversing in mid-July. For this near-Goldilocks situation (no US recession and economy holding up well but yet a dovish Fed) in the US to sustain, will require a lot of fine balancing act,” they wrote.
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