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Gold’s is the true bull run of the 21st Century

Ask Midas and he will tell you that gold is a class in itself. Gold is often called the barbaric relic and rightly so. It has bedeviled people for thousands of years as the ultimate store of wealth. Bappi Lahiri may be one of the best music composers of his generation but he is the most prudent investors too,literally wearing his love for gold on his sleeve.

Gold:The International Story

Gold has lived in tumultous times. It has been loved but it has also been reviled as responsible for financial crises and delays in economic recovery. After all, a gold standard prevents runaway monetary expansion. In 1973, the removing of gold backing of the dollar triggered the greatest boom in the history of gold with gold peaking at $ 850/oz in 1980,rising from $ 35/oz in 1973. Those were interesting times. Crude too had hit $ 100 a barrel only a short time earlier. Gold then saw a terrible bear market for the next twenty years that virtually killed confidence in gold as a store of value. Its obituaries were written and central banks, most notably the Bank of England unloaded the gold in their reserves.

Look at this chart from 1971-2005. You can see how the 20 year bear market in gold had lower tops and lower bottoms till 2000 when the trend suddenly changed spectacularly. It was almost as if it were echoing Jennifer Lopez in her millennium song ‘Waiting For Tonight’. At Y2K, gold launched itself into a bull run that has not ended yet.

Gold has seen big crests and troughs in its career

Note how gold took 25 years to get back to its previous peak but the actual upward movement took almost no time

 

The first chart covers gold’s trajectory till 2005, the year in which it recaptured 1979 highs once again. The other one covers the 2Ks till present. As you can see, it is a largely undisturbed trend except for except for brief periods of volatility in 2006, 2008 and 2011 (The latest one cannot actually be called a correction yet. It could also be the start of a bear market although I would bet against it).

The stellar run of gold in the new millennium

The stellar run of gold in the new millennium

Gold: the Indian Story

Indians have been gold bulls from the times of Alexander. We never had much of the precious metal naturally available in India but a long tradition of accepting virtually all our foreign trade payments only in gold and silver has led to Indians being the greatest hoarders of gold in the world.

The Indian belief in the value of gold has been vindicated time and again

The Indian belief in the value of gold has been vindicated time and again

However, let’s cut to the present.In the last 40 years, the experience of the Indian consumer has been very different. He has only seen rising prices. Gold imports were banned in the 1970s and thus smuggling was common.(Big B as Don was engaged in gold smuggling).This kept prices even higher than international prices. The graph below does not take that into account. There never have been bear markets except for two periods 80-86 and 96-01 when it dropped but not too significantly.Why is India so decoupled from the global markets?
The hero or villain depending on which side of the buy/sell equation you are is the INR/USD exchange rate.

The rupee weakens, then hangs onto a support, then weakens again

The rupee weakens, then hangs onto a support, then weakens again

It is rather obvious that the rupee has been on a long term downward trend and in spite of being less volatile in recent years, the current stabilization of the rupee at 48-50 instead of 42-44 is part of a larger structural weakness of the rupee. Even if gold prices fall internationally, a falling rupee takes it up.
This rather reinforces Bappida’s and the common Indian’s belief in the yellow metal. India consumes 900 tons of gold every year. Indians have between 20000-25000 tons of gold stored privately which is around 15% of the total gold mined in the word till date(165000 tons). The global gold output is around 2500 tons. Buying gold is no investment(except very recently)for Indians, it is sacred tradition. So we Indians actually drive the price of gold even if the prices in our spot markets do not reflect global trends.

The movers and shakers of gold:

Real interest rates:Gold acts inversely with real interest rates. This is a long term phenomenon that can actually be relied upon. In today’s low interest rate scenario, gold should rule the roost.

Liquidity: There has to be money to buy gold. Even if real interest rates are low and there is no confidence in the equity markets, gold would still collapse in the absence of liquidity. This happened in 2008 when a run on equity markets also led to a run on gold.

Dollar index: Being dollar denominated, gold moves inversely with gold. It is no coincidence that the gold lows of 1999 and 2000 coincided with lifetime highs of the dollar index.

Gold is Money: The non-stop printing of dollars by the US Fed is undermining the dollar.Central banks have turned net buyers in the last two-three years after decades of selling. There is no doubt that the world will have to rely less on the dollar in the future. Gold could very well be back as a reserve currency. Unlike paper currency, it is real and can be felt and touched and its writ is not determined by a government.

Hedge against hyperinflation: Yes, you read that right. In India, because of the depreciating rupee, gold does act as a hedge against inflation but it is not always bought when inflation goes up. Therelationship is more complicated than that. However, in a case of hyperinflation, there is no asset like gold. It is literally te only asset left standing. So if confidence in the fiat currency in which you hold your assets erodes or it devalues itself crazily, only precious metals can save you. Hyperinflation is a very rare event but it can never really be ruled out in an intrinsically flawed financial system.

China: China is also the world’s largest producer of gold but it exports none of it. Its central bank has also been buying gold externally and is rumoured to be building a gold war chest as a hedge against a falling dollar. China is likely to overtake us this year in terms of gold consumption.
Jewellery: In India as well as China, gold has its use as jewellery. In case the investment does not work out, physical gold could be converted into jewellery. Most families do need jewellery on occassions like marriage and so hedging the risk being forced to buy it at a much higher cost in the future is prudent. The physical asset or a gold ETF could be used for the purpose.

Naysayer arguments:

Useless Ponzi asset: Warren Buffett wrote this year that gold is an unproductive Ponzi asset that no use whatsover and is bought in the hope that it would someone would pay a higher price for it in the future. He is right but remember that Buffett held vast quantities of silver from 1997-2006 and mistimed his exit thus completely missing out on the bull run in the white metal.

Technicals: Gold has formed lower tops and lower bottoms after falling from its September peak of $1920/oz. It is currently at 1700. There is not a whole lot of strength in its movements. It has also been in a very long bull market and thus could fall a long way.

Too Many Bulls: There is no doubt that the number of people bullish on gold has increased greatly in 2011. The correction post September has reduced the number. Market peaks and bottoms are usually reached when the buyer seller ratio becomes extremely skewed. Saying this for gold is difficult because we do not see the average Joe giving advice on gold and buying it aggressively yet.

Do I buy it then?

The long term fundamentals for gold are very strong and specially for the Indian consumer, buying gold is never a bad decision. In the last few months, we have seen gold moving in a very narrow band between 27000-29000 per 10 grams while international prices have yo-yoed largely due to the rupee which has played the see-saw with international price movements and led to a cancellation of both factors.
An appreciation of the rupee could make gold cheaper but it is also equally true that if gold breaks out, 1920 is not too far. A close above those highs could take gold to any level. That could make gold completely unaffordable for those who need it for jewellery. Thus, if one does not have gold, accumulating it at present levels may not be a bad idea. Having said that, till it resumes its trend, it is as risky as equity. Do not treat it like a safe haven.

It’s All About Liquidity,Stupid!

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The Nifty has crossed 5500 and the Sensex is at 18300. There may be no core fundamentals backing a rally of this magnitude but that does not matter. As I wrote in my previous article, we are in a purely liquidity driven rally.

However, this rally has also taught me a lot in addition. First of all, rallies are powerful only when driven by liquidity, not fundamentals. Fundamentals play only a supporting role. The Fed’s unleashing of liquidity in 2009 kickstarted the recovery from the lows. The ECB’s unleashing has done it now.

It doesn’t really matter if there are no fundamentals because when money is cheap, risky assets like stocks will move up. It is also true that the markets will fall but that will happen not because of waning fundamentals but waning liquidity. Go back to 2008 and you will see that decreasing liquidity preceded the fall and the bottom was reached at the time of the worst liquidity crunch in a long, long time.

When there is a clear trend in stock markets, fantastic money is made in a very short time frame. However, then the fall, consolidation etc. comes which tempers the long term returns significantly. Thus as the time in the markets increases, the returns become far less impressive. We have witnessed a 20%+ rise in the benchmark indices and more in the midcap indices. People have made more much money in this time frame than investors have made in four years(even not adjusting for inflation.

The very long term is supposed to belong to fundamentals but that is entirely a function of the point at which the investor is evaluating his investment. Companies with great fundamentals languish at lows because there is no buying interest (no liquidity) while bogus companies run up like crazy.

The fundamentals basically are needed to sustain a stock at higher levels otherwise it falls when liquidity dries up. However, when liquidity for the entire market dries up, even strong stocks fall rapidly and so one can avoid losses only if one has entered at lower levels.

In toto, better to play liquidity for market trends than fundamentals. As long as liquidity continues to flow in the financial system, there will be no correction in the Indian bourses.

Markets at 16000, again!

16000. The figure invokes a very strong sense of déjà vu. We’ve been at 16000 once in 2007, thrice in 2008, twice in 2009, twice in 2010 and four times in 2011. The level has acted as a support for the market many times, most notably in 2010 when the market rebounded sharply both times it hit 16000. Support is the technical term but what it really means that the market found enough suckers to buy the market at that level.  Someone who bought into the Sensex at 16000 in 2007 has made no money for more than four and a half years. This level is almost 25% below the Sensex life high of 21000. At such high levels, the logic which is sold to investors for long term investment is that one should not look at the trailing twelve month P/E but the forward P/E. The forward P/E projection is usually 20-25% higher which is used to imply 20-25% growth in value of the index.

Going by this logic, an investor should have got 20% returns YoY since 2007 instead of zero or negative. Why has this not happened?

EPS: an analyst joke

Ignoring market gyrations, I will simply state the most basic reason. The Sensex has been overvalued for the past several years. EPS growth has never been even close to the levels predicted by analysts. In Jan 2008, Citigroup said that the Sensex at 21000 was trading at 22 times forward P/E. Thus they were predicting a Sensex EPS of 955 for FY09 (by the way, they had a Sensex target of 23950-25000 for the year.) Even 1000+ estimates were made by some. The actual EPS after twelve months was 792. The funny part is that the figure of 955 is the current EPS of the Sensex according to bseindia.com(13 January 2012 with Sensex closing value of 16154.62 and TTM P/E of 16.91. The data from NSE suggests a higher Sensex EPS for the twelve months ended Sept 2011 at Rs.1013. Citigroup like many other analysts had projected extreme bull run conditions into the future.  This is a recurrent phenomenon which has been seen this year as well. Bloomberg consensus estimates for Sensex FY12 EPS were at around 1250. I would be surprised if it achieves 1050.

Conflict of interests

These consistent overvaluations are not a mistake but part of a very concerted plan to lure gullible investors who are stupid enough to believe in ‘finance experts’. The models of these experts are so complex and they consider so much data that they give themselves and investors the illusion of actually knowing the subject. Yet, their own traders are unable to beat the market and their clients lose money. Guided broadly by some fundamentals, the markets then rally mostly on sentiment. The job of the analyst is to disregard this truth about sentiment and to justify every valuation in the park, howsoever absurd. That is where the expertise of the analyst actually is needed. When the market fell to below 16000 in one day of panic selling on 22 January 2008, everyone on CNBC was shocked at the extent of the cut and advised ‘long term investors’ to enter into the ‘correction’. It was good strategy as people liquidating positions had to sell to somebody and these idiotic comments were as much denial as malice. These comments to buy petered out by the time 10000 was on the Sensex which was the actual level to enter. Why I call 10000 as the entry point instead of 16000 is simple. Sensex TTM P/E in end 2008 was 824. Even if we assumed positive earnings of 10% instead of the actual negative 10% we would have come across 900 forward earnings for FY10. At a forward P/E valuation of 15x, the Sensex should have still traded only at 13500. However, the figures of 15-18x are usually used in bull markets. By the PEG theory, forward P/E should equal EPS growth. This would have implied fair value of the Sensex at 10x or 9000. I wish I was smart enough to realize all this then and had bought bucketloads of stocks then. The point I wish to make is that the livelihood of the financial companies depend heavily on the capital markets. Market over exuberance is extremely profitable as it leads to tremendous growth of the financial services industry. Senseless valuations and forecasts are much more profitable than sober ones.

Ramping up prematurely

On fundamentals, the market should never have touched 21000. It did not deserve the level then and does not deserve it today. It did not deserve 18000 either. The move up to these levels has only benefited a few traders and financial ‘experts’, giving them the license to make idiotic charts that project irrational returns. In the long run the market has survived at neither of these levels.Even when the green shoots were clear in 2009-10, Europe was a concern that had the potential to explode any time. From this time to mid 2011, analysts once again utilized the opportunity to profit from gullible investors by selling them products at 18000 and 19000 Sensex levels by nicely showing them charts of twelve month returns. Of course at these levels neither the debt crises nor commodity based inflation was priced in. They were back to the forecasts of yore projecting 25000-30000 for the Sensex as the ‘India growth story’ is still intact. The India growth story has been a much abused term. It was responsible for the decoupling theory of 2007 that famously predicted that Indian markets would not at all be affected at all by the subprime crisis.

Strategy of fooling long term investors

The analysts will never tell you that markets are not sexy. That would negatively affect their profession. The big investors, funds and brokerages always try their best to profit at the expense of the public. At the end of the day, the public is the one holding stocks at the highest levels. The brokerages quietly sell out in the rallies, the rallies themselves being engineered. As engineered rallies are costly to sustain, the the index retraces its gains after some time. Carefully observe the Sensex yo-yos in the last few years. You will observe a lot of trading ranges. These ranges have usually been broken on the downside in spite of consistent buy calls from brokerages. However, the public is left holding stocks from the highs of these rallies. If the institutional investors actually sold without creating artificial rallies, they would create precipitous declines. Instrumental in the artificial rally is the role of the momentum trader. No wonder that India’s stock market trading volumes are the highest in the world but the cash market volumes are in single digits. These artificial rallies have terribly low delivery volumes. When these rallies peter out, the value or long term investor is exhorted to save the skin of the large institutional investors who wants to sell without creating selling panic. These market manipulations are centuries old and still manage to find fresh losers.

The Future

If we assume 1150 as the Sensex EPS twelve months down the line, a valuation of 12x suggests fair value at 13800. Do I suggest buying at 13800? Yes, but only if you are not invested at present. Besides, a crack to 13800 could as well send the index crashing to 12000. My reluctance stems from the fact that Rs 1150 on a base of 13800 yields 8.3%. Risk free interest rates are at 9%+. Thus, unless we officially believe in monkey forces and the greater fool theory, there can be no justification for investing even at that level. I wholeheartedly believe in the greater fool theory as it has been the primary mover of Indian markets in the last five years but it is a theory only for traders, not for investors. The recent rally in the Sensex of 1000 points is in my opinion, nothing more than a suckers rally. Even if the index rallies to higher levels, there are no real fundamentals for an extensive bull run. A move higher would continue the long term bear market and draw more losers at higher levels (this is exactly the opposite of what a technical analyst will claim.) There has to be a change in fundamentals for a bull run. Look at the problems in Europe, US and now China. Every positive development claimed such as improvement in US GDP growth and unemployment numbers has only short term relevance as the underlying debt and related concerns cannot be wished away. China has had a huge real estate bubble and the voices of a soft landing following the bubble burst sound so 2007. I was a big bull from 2004-2008 but have been a net seller since May 2008. Secular bull runs start from compelling valuations, not from fair value or marginally overweight valuations. Bull runs are scripted in graveyards.

References:

http://www.moneycontrol.com Sensex Target of 23950-25000 in 2008 – Citi http://www.dalalstreet.biz/investor/2008/01/sensex-target-of-23950-25000-in-2008/
http://www.dalalstreet.biz/investor/2007/06/bse-sensex-forward-pe-chart/
http://capitalstock.wordpress.com/2010/09/10/mystery-of-sensex-eps/
advfn.com
Business Standard
Reminiscences of a stock operator by Edwin Lefèvre
equitymaster.com