Over the last few days, the Sensex and Nifty have slipped from their buoyant levels of the past. While there is a view in the market that this fall may only be temporary, there is enough reason to believe that stock markets are very likely due for a significant and persistent correction because of prevailing macroeconomic conditions.
How does one arrive at this conclusion?
Consider the above chart. The red line is real return in excess of the growth rate – which essentially captures the return on capital over and above that generated by economic growth. Simply put, this is the 10-year government security yield (the risk-free rate) adjusted for expected inflation and growth.
The blue line is the dividend yield (dividend/price) of the Nifty at a quarterly frequency. A quick look tells us that the two lines have tracked each other quite well over the last 15 years. However, of late, the dividend-to-price ratio seems to have strayed off a bit – especially since 2016.
This clearly indicates that the current price levels are too high and untenable with the prevailing real interest rates. Further, it is highly likely that with the recent hike in interest rates, this divergence is going to become increasingly shaky and the prices will eventually have to converge to lower levels so as to observe the close correlation of the past.
What makes us so sure that it is the prices and not the dividends which are at fault? To understand this, let’s take a look at the chart below.
This chart plots the Nifty index with and without dividends. While the index values have been on a secular increasing trend over the last years, the dividends on the Nifty (green bars) have more or less been stable in annual terms, especially over the last three years. Therefore, the movement of dividend yield (D/P) in the first chart is presumably mostly coming from the movement in prices. Simply put, market prices are too high relative to the dividend, which is pushing the dividend yield downwards.
Thus far, we have concluded that prices are higher relative to interest rates as observed historically. What makes it so sure that this historical correlation will continue to be observed in future?
This is where theory comes in by allowing us to place stock market trends in conjunction with prevailing macroeconomic conditions – something which the usual analysis on financial ratios in isolation (such as the price-to-earnings ratio) fail to incorporate.
Over longer time periods, the expected real return from a stock is essentially going to come from two sources: the dividend a stock generates over time (referred to as dividend yield) and the growth in such dividends – all measured after adjusting for inflation. Of course, in the short run, the price appreciation is also a part of return, but over an extended period of time, the ratio of price to dividend will ultimately sober up to its long run average level and the expected price appreciation will simply map into the growth in dividends. Consequently, this long-run identity simply tell us that the expected real return must equal dividend yield plus expected growth in dividends.
This is simply an identity without any assumptions on rationality or the efficiency of markets. We can rearrange the three terms as: dividend yield = expected real return – expected growth in dividends.
The first term, dividend yield is easily observable in the data. The second term, expected real return, is where matters get tricky because it is not directly observable. Real return is simply nominal return (using the popular proxy of 10-year government bond yields) adjusted for expected inflation.
Now, how does one arrive at expected inflation? While the actual inflation is easily observable, expected inflation is not. The Reserve Bank of India (RBI) conducts inflation expectation surveys, but these are rather limited in scope. To address this limitation, we use a method well-developed in the research literature which statistically teases out inflation expectations dynamically by identifying persistence in inflation by auto-regressing the historical inflation data on a roll-over basis.
The third term: growth in dividends, is basically the growth in profits of a company and for an index, it can be roughly proxied by the growth in GDP estimates.
What does all this theory buy us? Very broadly it tells us that the long-run trends of the left hand side of the identity must move in tandem with the right hand side, on average. We qualify it with “on average” because we cannot exactly define the time-frames which correspond to the short-run and long-run, however, what we know for certain is that the market valuations cannot remain in a permanent violation of this identity.
Therefore, any deviations in this co-movement would suggest us if prices are higher or lower given the level of expected real returns. The deviation observed in the first chart suggest that a downward correction is imminent. Of course, one cannot put a strict timeline on this downward correction in prices except say that there the downward pressure is already veering the market towards moderation at this point in time and is here to stay.