I track three ratios very closely. These are Nifty’s Price/Earnings (P/E), Price/Book (P/B), and Dividend Yield.

Each of these ratios compares Nifty’s price level, which is observable, with fundamental factors which may or may not be observable.

While dividends are observable, earnings and book values are mere estimates made by accountants and managements. And lately both of these groups of people have been very aggressive.

Given that presently there is plenty of funny accounting going on in Indian companies (e.g. non provision of interest on convertible debt, aggressive accounting for impairment of assets, non recognition of forex losses on “hedging” activities etc.), I feel it’s much safer to rely upon objectively measured dividends, instead of subjectively estimated earnings and book values. The chart below shows Nifty’s dividend yield since 1999 till date.

Over the last ten years, Nifty’s dividend yield has ranged from a low of 0.82% to a high of 3.18%.

Now let’s look at what’s happened to Nifty’s returns in the past at different ranges of dividend yields. My colleague Ravi checked this out and his results are given in the chart below.

Ravi split the range of Nifty’s dividend yield into ten buckets (the bucket with the lowest yield is when Nifty has been most expensive and vice versa) making sure there were enough data points in each bucket. He then measured Nifty’s return over the next three years for each bucket. The results are highly symmetrical - i.e. the lower the dividend yield , the lower the three-year forward returns, and the higher the dividend yield, the higher the three-year forward returns.

For example, on days  - there were 368 such days since Jan 1999- when Nifty was in the cheapest bucket (dividend yield ranging from 2.11% to 3.18%), a blind strategy of simply buying Nifty would have produced a three-year forward average return of  positive 185%. Not bad at all!

This average return would, however collapse to a negative 32% if you had bought Nifty on days when it was in the most expensive bucket (dividend yield ranging from 0.82% to 1%). There were 57 such days since 1999.

Nifty’s current dividend yield is 1.11% and its presently in bucket # 2. Another 11% rise in Nifty from present levels of 4,636, with no corresponding change in dividends will push it into the most expensive bucket # 1.

Unless corporate earnings (and dividends) rose without a corresponding rise in stock prices, dividend yield will remain near historically low levels and if history is any guide, it’s warning us to be wary about investing in large cap stocks at current prices.