Which Market is Wrong?
Below is an extract from a commentary originally posted at www.speculative-investor.com on 18th November 2007.
Which market is wrong?
The top section of the following chart compares the BSE/gold ratio (the Indian stock market in gold terms) with the GYX/gold ratio (the Industrial Metals Index divided by the gold price). It clearly shows that both the industrial metals sector of the commodity universe and the Indian stock market trended upward in real (gold) terms from 2003 through 2006. It also clearly shows that a divergence began to develop in October of 2006 and that this divergence has become rather dramatic over the past 6 months. In fact, with the GYX/gold ratio having just hit its lowest level in more than two years it is obvious that the industrial metals sector embarked on a cyclical BEAR market in gold terms during October of 2006, and yet the BSE has continued to trend upward relative to gold.
For many years prior to October of 2006 the trends in the industrial metals sector and the Indian stock market appeared to be inseparable. Their performances relative to gold were, in turn, indicative of what was happening to global growth, with the declining trends of these markets (in gold terms) during 2000-2003 representing the slow economic growth and contracting liquidity of that period and the subsequent rising trends representing a worldwide expansion of liquidity and faster economic growth. It is therefore somewhat strange that the markets have taken such divergent paths since October of last year, and especially since the middle of this year. Is one of these markets wrong, and, if so, which one?
For two main reasons, we think the Indian stock market is sending the wrong message. The first of these reasons relates to the bottom section of our chart.
The bottom section of the chart shows that prior to this year the intermediate-term trends for both GYX/gold and BSE/gold were the same as the intermediate-term trend for the US yield-spread (represented, here, by the ratio of the 3-month T-Bill yield and the 30-year T-Bond yield*). Specifically, GYX and BSE were in upward trends relative to gold when short-term rates were rising relative to long-term rates and in downward trends relative to gold when short-term rates were falling relative to long-term rates. But while the GYX/gold ratio has continued to move in line with the US yield-spread, the BSE/gold ratio has, to date, totally ignored the yield-spread's major trend reversal.
Now, it could be argued that the fundamental underpinnings of the Indian stock market justify its divergence from the industrial metals group. After all, it doesn't necessarily follow that reduced demand for industrial metals stemming from a downturn in the US housing market should be associated with slower growth in India.
Which brings us to our second reason for thinking that the Indian stock market is wrong: the primary propellant of this year's rise in the Indian stock market has not been a significant improvement in fundamental factors, but has, instead, been the general willingness of 'investors' to bid-up prices despite very high valuations. The BSE Sensex 30 Index, for instance, currently has a P/E ratio of around 25 and a dividend yield of less than 1%.
In our opinion, at some point over the next several months the BSE/gold ratio will plunge to a sufficient extent to bring itself back into line with the GYX/gold ratio.
*Note: we normally chart the yield-spread in such a way that a rising line is indicative of long-term interest rates rising relative to short-term interest rates, but in this case we've charted it such that a rising line represents a decline in long-term rates relative to short-term rates.
Gold or Tech?
Two weeks ago we mentioned that Microsoft (MSFT) had broken upward from a 7-year base and that we would be buyers on a pullback to around $33. Then, in the email sent to subscribers early last week we mentioned that Monday's decline to the low-$33 area had prompted us to take an initial position in the stock.
An investment in MSFT appeals to us at this time for five reasons: First, the breakout from the long-term base evident on the following chart suggests that the stock will make significant additional gains over the coming year. Second, the company is growing its earnings at a robust rate. Third, it has a truly multi-national business and its earnings growth is therefore not dependent upon the health of any one country's economy. Fourth, it has a pristine balance sheet and is largely unaffected by the on-going debt crisis. And fifth, it has pricing power (very important in a high-inflation world).
One concern we have is that we can't imagine a scenario in which there's a sufficient decline in monetary confidence to cause the gold price to move above $1000 combined with sufficient demand for large-cap tech stocks such as MSFT to keep these stocks in upward trends. In other words, we are concerned that a long position in gold is at odds with a long position in MSFT.
One way of reconciling this seemingly self-contradictory stance is to recognise that each position is justified based on individual market analysis even though the positions appear to be inconsistent with each other. Another way is to simply appreciate that there are many investment baskets and no law that says we must choose just one in which to put all of our eggs. We are not fans of diversification for its own sake because the more someone diversifies the more mediocre his/her performance will become, but we recognise that it's never prudent to bet everything on a single investment idea. We therefore tend to have one big basket -- a golden one, at the moment -- and a few smaller baskets.