Naturally, we should expect the earnings yield (i.e trailing earnings of index stocks / market capitalisation of index stocks or alternatively, known as the inverse of price-to-earnings ratio) of stock market index to be relatively higher than the yield of government bonds / securities.
Malaysia: Earnings Yield of FBMKLCI vs 10 Year-Malaysian Government Securities, MGS)
As shown above, using a 10-year time frame (commencing 2006), the FBMKLCI’s earnings yield is generally higher than the yield of the 10Y MGS. The lower the yield differential between earnings yield of the equity index and MGS yield may indicate potential overvaluation of the equity index.
From Nov 2006 – Nov 2007, the gap between earnings yield and MGS yield narrowed. Subsequently, there was a significant drop in the FBMKLCI index (starting in early 2008), coinciding with the Global Financial Crisis (“GFC”).
Post-GFC (starting in Q4, 2009), the differential yield gap widens, rising in tandem with a rising FBMKLCI.
Since early 2013, there was a declining differential yield gap between earnings and MGS, to be followed by a declining FBMKLCI (since mid Jul 2014).
Alternatively, the yield differential graph can be shown below (whereby the yield differential is shown as a percentage of 10Y MGS’s yield). The median yield differential is approximately 57%, i.e the earnings yield of the FBMKLCI index should be 57% higher than the current 10Y MGS yield. Currently (as of 30 Sep 2016), the yield differential is very close to its long term median yield differential (this does not indicate whether FBMKLCI is either significantly overvalued or undervalued).
Malaysia: Dividend Yield of FBMKLCI vs 10 Year-Malaysian Government Securities, MGS)
In contrast to earnings yield, the higher the yield differential (dividend yield minus 10Y MGS yield) may indicate potential undervaluation of the equity index. The above graph shows that in most periods (since 2006), the dividend yield of equity index is relatively lower than the yield of the 10Y MGS, possibly attributable to the fact that Malaysia is a developing economy.
The percentage of yield differential is shown below, whereby the current yield differential, as of 30 Sep 2016 is negative 12.3% (Earnings Yield – 10Y MGS Yield / 10Y MGS Yield), which approximates the long term median yield differential of negative 13.5% (this does not indicate whether FBMKLCI is either significantly overvalued or undervalued).
As shown in the above simple desktop analysis, the FBMKLCI does not appear to be significantly overvalued or undervalued if based on yield differential metrics. Nevertheless, we would expect the yield differential to narrow or widen if the following happens:
- Continuing decline in corporate earnings due to challenging economic environment
- If there is a future cut in the Overnight Policy Rate (“OPR”) by Bank Negara, this will potentially translate into lower yield for the MGS. See news
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