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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.
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