Investment professionals frequently use bond yield to estimate movement in equity market. One of them is Bond Equity Earning Yield Ratio, known in Wall Street parlance as BEER. Today we shall discuss this term and see this ratio in the context of the Indian market.
What is BEER Ratio?
Beer ratio in stock market
Basically BEER ratio compares 10 year Treasury bond yield to the earning yield of the stocks or stock index; earning yield is the reverse of the price to earnings (P/E) ratio. In other words, numerator of the ratio is represented by a benchmark bond yield (which could be 5 yr or 10yr treasuries), while the denominator is represented by the current earning yield of the stock benchmark (such as Nifty or Sensex).
How do we interpret BEER Ratio?
A BEER ratio of 1 means that both equity and bond market have equal level of perceived riskiness (or both equity and bond markets are fairly valued). BEER ratio greater than 1 means that equity market is overvalued, while BEER ratio smaller than 1 means that equity market is undervalued.
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BEER Ratio for Indian Market
We tried to use the above ratio by taking 10yr India Government Bond Yield as numerator and Nifty earning yield as denominator. Result is presented in the below chart:
Chart 1: BEER ratio
Chart 2: BEER ratio and Nifty
BEER ratio for Indian market comes at c1.8 indicating that the Indian equity market is currently overvalued. This can also be corroborated by comparing current P/E ratio to historical average P/E ratio of Nifty. Taking historical data from Jan 2000 to till date (more than 14 yrs), current Nifty P/E ratio of c20.8x is fairly high as compared to historical average P/E ratio of c18x (Median-18x; High-28.4x; Low-10.68x). This also implies that any reduction in interest rate (bond yield) would make equity market more attractive.
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Dark side of the BEER Ratio
BEER ratio appears to have zero predictive value as pointed by many experts in US. Accordingly, US stocks had high BEER ratios indicating they were overvalued in August 1982 and October 1990 — two of the best times to buy stocks historically. Meanwhile, in February 2008, the ratio was well below 1, and stocks fell 50% in the next 12 months.
Experts also feel that comparing bond yield to stock earning yield is useless as they represent two different asset classes. While government bonds are contractually guaranteed to pay back the principal, stocks promise nothing. Similarly, unlike the interest on a bond, a stock’s earnings and dividends are unpredictable and its value is not contractually guaranteed.
In the next blog, we shall discuss another way we can use bond yield to analyze equity market.