Well, beer doesn't actually tell us anything about stock markets, but BEER does. Confused? Market analysts love acronyms - especially those which make mundane stuff look exciting. So, while some of the more nerdy varieties talk about yield gap - the difference between earnings yield and bond yields, the more creative varieties came up with a spiffier term: BEER - bond equity earnings ratio.

How do you make this BEER?

In simple terms, what BEER does is to compare yields on debt vs equity - the two asset classes that compete constantly for investor allocations - to give investors a sense of relative attractiveness of one over the other. Since market valuations fluctuate and so do bond yields, keeping a tab on BEER helps investors understand relative attractiveness through a simple single number.

Lets look at how BEER is constructed and then figure out what BEER is telling us about Indian markets now. There are 2 components - bond yields and earning yields. Bond yield is simple - the yield on the 10 yr G-Sec. That's currently hovering around the 6.8% levels. That's the annual return you get if you invest in a 10 yr Government bond.

Earnings yield is simply the inverse of the popular P/E ratio. So, if the Nifty is currently standing at 10,300 levels and the Nifty earnings (last reported - historical basis) is 392, the P/E for the Nifty works out to 26.3 (10,300 / 392). The market P/E is what most of us are familiar with, and gets reported frequently. Earnings yield is the inverse of P/E - all you do is flip the numerator and denominator around. So its earnings/price which is 392/10,300, which gives an earnings yield of 3.8%. What this tells us is that if the collective earnings per share of all the 50 Nifty stocks is Rs. 392, and you are buying the Nifty at 10,300, you are essentially getting a 3.8% annual earnings yield on your investment. Another way to come to this number is by simply looking at the published market P/E - which is 26.3. If I invest Rs.100 in the market at a P/E of 26.3, I am paying 26.3 times the annual earnings. So, the annual earnings must be 100/26.3 = 3.8%.

How does my BEER taste?

That was the calculation part. Now comes the interpretation part. So, we have bond yields in India currently at 6.8% and equity earnings yields at 3.8%. As a rational investor, which yield looks more attractive: 6.8% or 3.8%? What the BEER does is simply put bond yield on the numerator and earnings yield on the denominator to get a single number. So, in this case it would be 6.8%/3.8% = 1.8.

As theory goes, when BEER is above 1, it signifies that equity markets are overvalued relative to bond markets, and when BEER drops below 1, the signal is that equity is a great buy. At 1.8, BEER is telling us that equity markets are grossly overvalued relative to bond markets.

How can I make my BEER taste better?

Lets look at a couple of scenarios on what can take the BEER closer to 1. As we all know, the big worry is that markets have run ahead of the much-anticipated earnings growth - but markets continue to hold up in the belief that strong earnings growth is around the corner.

If earnings grow 25% and market remains flat (and bond yields continue at current levels), it does bring BEER down, but not close enough to 1. Conversely, if earnings disappoint and remain flat and market corrects by a hefty 25%, that too brings BEER down sizeably, but not yet to 1. To get an equilibrium between bond yields and equity earnings yields, we need both to happen - earnings growth of 25% and a deep market correction of 25%. That's quite a tall ask!

So, how bad is my BEER?

Does this mean that we should be preparing ourselves for a big crash? Need not be the case. The history of BEER readings in India is that it tends to be in the 1.2 to 1.6 range for the most part. Readings at 1.0 and 1.8 typically happen at extreme valuation levels on either side. As long as BEER stays within 1.2 to 1.6, history suggests that there is no strong signal that BEER is giving us. But history does suggest that 1.8 is high. So, while we don't need to see BEER crash from 1.8 to 1.0 to call the market fairly valued, we do want to see it going back into that comfort zone of 1.2 to 1.6. A sideways market for the next year and a 20% earnings growth can well do the trick.

Let's go bottoms-up with our BEER on that thought!

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