A Chartist's View on Sensex versus Gold

In this issue:

» Banks' corporate loans at 7 year low

» Is India Inc. in a deleveraging mode?

» Today's market update

» ...and more!

Our colleague and charting specialist, Apurva Sheth, editor of Swing Trader, recently dug deep into his charts to confirm his view on our 'Sensex 70% upside' prediction. He wanted to corroborate or contradict our long term-view on stocks with his opinion on the near-term potential. He provided our subscribers with three charts. And he gave the opinion that every smart trader would need on near term Sensex upside based on chart patterns (requires subscription). Rahul, our team, and I would never be able to tell you something like that.

So this time when we gave an opinion on long term allocation between equities and gold, we thought why not give you a view on their charts too? And who better than Apurva to help us with that?

Once again Apurva did some solid chart reading...

And this time he came up with a technique to optimize Gold and Sensex returns with a simple tool - Ratio Charts. With this tool one can increase or decrease exposure in gold or equities to optimal levels.

So make sure you read Apurva's every word carefully!

What's a better investment - equities or gold? Everyone has their favorite depending on their views and biases (sometimes very strong views). But you can't deny they both put up a tough fight.

Rahul Shah recently shared his thoughts on this perennial debate.

He argues that the Sensex is a good proxy for India's economic potential. It represents the largest companies from which you can expect a certain earnings stream. Gold, on the other hand, is the perfect inflation hedge. It is real money and the only currency that retains its purchasing power over the long term.

Equities fulfill the investment objective of growth. Gold meets the objective of safety. But as an investor, what should you do? Invest in one? Ignore the other?

Never. You should invest in both. You should always diversify your investment portfolio across both assets.

But gold and equities do not perform well all the time. At times, gold will outperform the Sensex and vice versa. So if we are able to identify when one has the advantage over the other, we can optimise our investment returns.

I will show you how by drawing a simple ratio chart of the Sensex to gold.

Ratio Chart of Sensex to Gold

I have divided the price of the Sensex by the price of ten grams of gold traded on the MCX from 2004 and plotted the values on this chart. The base or starting point for both gold and the Sensex is 100.

The ratio trades in a range of 50 to 200. You will notice the line mostly trends up from January 2004 to January 2008. The Sensex outperformed gold by a wide margin during this period. This was when economies across the globe were firing on all cylinders. India was no exception, and the buoyancy was reflected on the benchmark indices.

But the line fell sharply after topping out in 2008 and hit the bottom of the chart in March 2009. Since then, the line has traded in a range of 50 to 110.

How can we use this chart to optimise our returns?

We can use the Sensex-to-gold ratio as a tool to calibrate our exposure in these asset classes. You can reduce exposure in gold and increase exposure to the Sensex or equities when the ratio is near the bottom or close to 50 levels. This is when equities are generally beaten down compared to gold, so it makes sense to increase your allocation to equities.

When the ratio is close to 110, one should consider reducing exposure to the Sensex or equities and increasing exposure to gold. This has worked well over the last seven years when the economy has struggled.

Going forward, if the Sensex-to-gold ratio is significantly below 110, and if the Sensex looks grossly undervalued, one can continue with a greater exposure to equities. However, once the ratio touches 110, it's time to assess the overall economic environment. If it isn't convincing, then it's time to reduce your allocation to equities and increase you gold holdings.

That's how you use charts to adjust your exposure to gold and equities for optimum returns.

On what basis do you decide your allocation to gold and equities? Let us know your comments or share your views in the Equitymaster Club.

2.55 Chart of the day

Vivek Kaul recently gave a very detailed insight into why banks' deposit growth is at a 53 year low.

Here is what he wrote...

• Banks make loans from deposits which they are able to raise. And if the deposit growth is almost at an all-time low, their ability to cut interest rates on their loans, will be limited. If banks cut deposit rates any further, the deposit growth will fall further and this will hurt their ability to give out loans.

He elaborated further...

• The point is that if the loan growth does pick up a little more from here, the incremental credit deposit ratio is likely to get worse in the days to come. If we take this possibility into account, banks will have a tough time cutting down their deposit rates any further. And that being the case, the chances of lending rates being cut further are limited.

So we are hardly surprised that even banks' incremental lending to corporates is currently at a 7 year low.

But what is worrying is the fact that bank lending to the infrastructure sector accounted for a third of total loans in FY16. Moreover, last fiscal, bank lending to the struggling metals and metals sectors accounted were 15% of corporate loans. Putting it bluntly, over half of bank credit to industry is to the troubled infrastructure and metals sectors. Over 55% of the incremental corporate loans went to the infrastructure sector. Another 38% went to the iron and steel sector. Now, unless there's a turnaround soon in these businesses, the lenders are bound to be in deep trouble.

Corporate loans at 7 year low. But to troubled sectors!

As you know, we have been claiming that Sensex and other bluechip companies are likely to deliver upto 70% earnings upside over the next three to four years. Why do we feel so? Well...it is a function of probabilities and basic statistics.

You see, India Inc.'s earnings quality and growth has been at its multi-year low in recent times - especially in the last two years. Asset turnovers are at their decadal lows. The same holds true for the profit margins as well. This has only gone on to impact the companies' earnings quality, which to an extent has an impact on valuations their stocks garner.

While the investment cycle is yet to take off, we do believe that reversion to mean only increases the odds of Indian companies reporting above average growth rates going forward. And this earnings growth will only get fueled by the falling interest rates coupled with the fact that Indian companies are in their deleverage mode.

As reported Business Standard, State Bank of India has released an economic update that suggests Indian companies are deleveraging in a meaningful manner. As per the report, out of the 200 companies that were studied, 30% of them have reported lower debt levels as compared to the previous fiscal. The total debt reduction for this lot stands at about Rs 69 billion. Sector wise, the sharpest decline has been in the cement, finance, trading and fertilizers spaces.

We believe such a trend only reinforces our belief that the odds of fetching good returns from the best bluechips are stacked in your favour currently.

By the way, the StockSelect team is working on a report on bluechips in the Sensex and beyond it have high earnings growth possibilities. Expect more update on this in the next 30 days.

• HDFC or State Bank of India?
  Tata Motors or Maruti Suzuki?
  Infosys or TCS?
  

These are the kind of questions we've answered for more than 20 years now...

However, we no longer want to just tell you which stock to buy. Instead, we want you to know about the complete stock-picking process that goes behind all our recommendations. How we analyse the business, its management, its moats...and so on. Yes, these are the secrets we've run our business on for the past 20 years. And we have revealed it all in Equitymaster's first and ONLY published book on smart investing.

At the time of writing, the Indian markets were trading marginally weak with the Sensex trading lower by 44 points or 0.2%. On the other hand, small and mid cap stocks were in favour as their representative indices were trading higher by 0.13% and 0.05% respectively. While healthcare, and consumer durables stocks were in favour today, those from the oil & gas and telecom spaces were bearing the profit of profit booking.

4:50 Today's Investing Mantra

"I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life" - Warren Buffett