Lighten up on stocks, add gold now

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Portfolio risk can be reduced by adding diversifiers such as bonds and gold at this point in time.
Portfolio risk can be reduced by adding diversifiers such as bonds and gold at this point in time.

Aarati Krishnan

It has been nothing short of breath-taking, this stock market rally that took wing in early March. Paying no heed to the doubting Thomases, rising stock prices have more than doubled the value of BSE Midcap and Smallcap indices, thrown up as many as 130 multi-baggers from the BSE 500 basket and nearly doubled India’s stock valuations.

All this, however, is no reason for complacency; but for caution. Investors who have seen substantial gains on their equity portfolio should resist the temptation to let prices run ‘just a little’ further and begin to take profits. Reducing portfolio risk by adding diversifiers such as bonds and gold should also be considered now.

Valuation vaults

The price-earnings multiple for the Sensex, which was beaten down to 11 times (trailing 12 month earnings) during the March lows, today stands at 20.4. Even without joining the debate on the various alphabetical forms that a recovery may take, today’s stock market valuations appear expensive, on two counts.

One, at a PE of 20 times, the Sensex valuation is well above the historic comfort zone. Over the past ten years, the Sensex has enjoyed an average PE of about 17. The lowest PE the index recorded during this period was 8 and the highest 25. That goes to show that, not only is the Sensex now stiffly priced relative to historic trends, it is also hovering close to the higher end of its trading band.

The market meltdown of 2008 began when the Sensex PE breached 23 times and the dotcom crash unfolded when the number hit 25.

Second, with emerging markets (India included) outperforming in this rally, a large valuation gap has opened up between the emerging markets (including India) and the mature ones.

The Sensex’ PE ratio of 20 today is at a sizeable premium to the Dow Jones Industrial’s PE of 13.5 and the FTSE 100’s valuation of about 11 times. It can be argued that Indian stocks deserve a premium because India will manage higher economic growth this year than the rest of the world. But the uncertainty is about how big that premium needs to be.

This stock rally has clearly been driven by global investors bypassing their home markets to increase their emerging market allocations, as the latter seemed to offer better growth prospects during the slump.

What happens when this relative growth differential narrows, and the US economy begins to chart a recovery? Would global investors then prefer to re-allocate funds to cheaper stocks back home?

It needs to be borne in mind that the premium already built into Indian stock market valuation limits the room for further upside.

The stellar gains also make the Indian market more vulnerable to a bout of re-balancing by global investors. It is a worrying sign that even domestic fund managers are today using only technical or liquidity-based arguments and not earnings-driven ones, to justify the rally.

Call on liquidity

All this does not mean this stock price rally will come to an end this week, or even this month.

After all, history has shown us that stock prices can remain in the expensive zone for an extended period before they revert to mean.

However, liquidity flows can be notoriously difficult to predict. Therefore, no investor should plan on riding out a stock market rally into its last legs. After all, if no one could predict the about-turn in global liquidity flows in March, it stands to reason that no one would be able to call a change in their direction, today.

Time to re-balance

All this suggests that it may be prudent for investors to lighten the risk on their equity portfolios at this point in time. They can do this by:

Re-balancing their stock market exposure which is likely to have edged up substantially, by taking selective profits

Reducing exposure to high Beta sectors and stocks, that have led this particular rally

Increasing the cash component on their portfolio

One final measure to reduce the vulnerability of your portfolio to a stock market meltdown would be to add an exposure to gold, through gold exchange traded funds. The reasons for this recommendation are threefold.

One, given that both the global stock and commodity markets have moved in tandem in this rally, both asset classes are equally vulnerable to the exit of momentum money.

Gold, on the other hand, is not as exposed to this risk, because of its modest returns since March. Gold ETFs in India today trade at much the same prices as they did in March, at about Rs 1,500 a unit.

Two, gold has historically enjoyed a negative correlation with stocks and has delivered positive returns during periods of stock market mayhem.

Yet, the fact that global gold prices have actually held steady since March 2009 is a sign that buying interest in the precious metal remains alive and well.

Three, Gold ETFs in India derive their returns both from the international gold price trends and the direction of the rupee vis a vis the dollar.

As a reversal in FII flows from India would inevitably weaken the Rupee, Indian gold ETF investors can expect to reap a double benefit if a stock market correction commences.

One final caveat. Investors are advised to use gold only as a diversifier for their portfolio as its long-term return record isn’t great. A 5-10 per cent allocation in your portfolio to gold ETFs should suffice.

Related Stories:
There is more to investing in gold than the jewellery
Secondary market more rewarding than IPOs
Gold ETFs outperform other assets in last 1 year

(This article was published in the Business Line print edition dated September 6, 2009)
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