Why Bond Market Matters to Stock Market Investors

Many market experts are advising investors to book partial profits. The reason for giving such an advice is because Indian equity markets are trading at all-time highs and are expensive on various parameters.  Leading equity indices are touching new highs every month without any commensurate improvement in corporate earnings. Most of the increase in stock prices are driven largely by expansion in price-earning (PE) multiples. The stocks are trading at a level previously reached only during 1993-94, 2000 and 2008.

One of the factors that will determine if the stock markets will continue their dream run and sustain higher valuations is what happens in the bond market. The basic finance theory suggests that lower interest rates support higher valuations. The logic behind this is that as interest rates are one of the components used to discount the cash flows of a company to find the valuation, a lower interest rate means lower discount rates and, hence, higher valuation of stocks. On the other hand, higher interest rates mean lower valuations. The second reason for such inverse relation is that as interest rates slide lower, investors shift their money from the bond market to equity market, leading to higher valuations for the equity market.

As logical as that sounds, the exact opposite has occurred on many occasions over the last few years; stocks and bonds have risen and fallen in tandem. The current scenario reflects the same when both bonds and PE ratios are rising at the same time. This normally happens when too much liquidity chases too few investments, which is due to unconventional steps taken by various central banks to revive sagging economy.

The reason why it matters to investors because when stock and bond prices are moving in opposite directions, it signifies a change in the market. Many times, it is used as a leading indicator of any change in the investment horizon. Rising bond prices may indicate that investors are worried about the macroeconomic scenario of the economy or scared of stock market’s valuation.

Therefore, purely on the basis of the relationship between bond prices and stock prices, we may see a correction in the markets going forward. Nevertheless, we have not reached the peak yet and we may see some more time before liquidity (both domestic and foreign institutional investors) starts pouring into the Indian economy helping equity market to sustain higher valuations.