The Sensex is now over-valued compared with the 10-year government bond, making stocks look unattractive. This is because the earnings yield of the BSE index stands at 4.78 per cent while yield on 10-year government bonds stands at 8 per cent.

Simply put, this means an investor can earn 8 per cent on her money without taking any risk as government bonds are considered risk-free. If she chooses to invest in Sensex stocks, they will earn her much lower. Broadly speaking, this means the chances of high return on stocks, a la 2009, now look bleak.

Earnings yield is nothing but earnings per share for the most recent 12-month period divided by the current price or the index level and is expressed as a percentage. According to BSE data, the 12-month trailing earnings per share of Sensex is Rs 823 at Friday’s close of 17,167

Money managers often compare earnings yield of a broad market index (such as the Sensex) with prevailing interest rates, such as the 10-year bond yield. If the earnings yield on stocks is less than the rate of the 10-year government bond yield, stocks as a whole are considered overvalued. That’s exactly what has happened now. There is more than 3 percentage points difference between bond yield and the Sensex earnings yield. For stocks to be under-valued (and thus look attractive), the earnings yield should have been more than bond yield. Theory suggests equity investors should demand an extra risk premium of several percentage points above the prevailing risk-free rates (such as government bonds) in their earnings yield.

The Sensex’s wobbly movement in the past few months can be attributed to the absence of this risk premium. While the earnings yield gap (trailing earnings yield minus 10-year treasury yield) has a long-term average of 4 percentage points, this gap has always indicated bubble valuations. For instance this was the case during 2007-08. As such, only long-term stock investors can expect to reap rewards from present levels. From the valuation perspective, market experts don’t feel Indian stocks are under-valued now.

Ridham Desai of Morgan Stanley said: “The market’s valuations do not appear attractive to us, although neither are they stretched.” His best-case scenario projection for the Sensex should give 15 per cent return in 2010 while in the worst case, the index may test 11,600 level.

Although, the earnings yield for the Sensex may improve if analysts upgrade earnings outlook, experts like Dr Carlos Asilis, chief equity strategist at Prabhudas Lilladher, have advised clients to remain defensive. “The Indian market valuations, relative to global emerging market peers, continue to remain unattractive. As such, we expect Indian equities to trade in line, at best, versus the emerging market peers over the coming months, and it is more likely to under-perform modestly,” Asilis said.

Nischal Maheshwari, head of research of Edelweiss, says “In spite of this continued uptick in the economy, the market has been cautious and range-bound, partly due to lower-than-expected liquidity in the secondary market.”