Equities have lost a bit of their sheen recently, as the markets have been range-bound for quite some time. Many retail investors seem to have been attracted by gold, with the old wisdom that gold is the best investment once again holding sway. In fact, some are now shifting to silver, following its meteoric rise even ahead of gold, doing the exact opposite of what the most successful investment sutra stipulates: buy low, sell high.
But let's dig a little deeper and see if there is any fundamental reason that will further fuel this rally in precious metals. In the case of silver, global production increased by more than 120mn ounces in the past six years. But, industrial demand increased by only 100mn ounces, while the demand from the photography segment actually declined by 100mn ounces due to digitalisation. Hence, there has been no increase in net genuine demand at all for silver! So, where did all those 120mn ounces of extra silver go? The large chunk has been absorbed by investors, with no reference to real-world demand-supply dynamics! (Source: The Silver Institute).
Since 1985, silver prices have exhibited an almost 95% correlation with gold prices. So, when silver disregarded its own demand-supply dynamics as well as its correlation with gold prices and its price rose by a gravity-defying 3x in the last eight months, it was only a matter of time before it retreated. Even at current levels, I would advise investors to tread with caution as silver prices are still outperforming gold by 80% from a one-year perspective. Let's look at gold. The noble metal has given an almost 20% return per annum over the last three years. With gold prices at all-time highs, one needs to be doubly sure of its underlying fundamentals. Not having significant industrial uses, gold's value lies in its perception as a hedge against inflation, as a safe-haven investment — a perception ingrained since ancient times. But has the inflation hedge logic really worked in the past few decades? In fact, adjusted for inflation, gold has given negative returns since 1980. (Source: GFMS).
Even in absolute terms, gold has been known to stagnate for years and years before giving returns. Is it really a big surprise then that the modern financial systems have over the past several decades allowed people to invest in productive financial assets that accelerate GDP growth (case in point, China and now India)?
Naturally, equity investors have been able to enjoy a well-deserved share of this immense wealth-creation. Taken over a 10-year period, equity markets of BRIC economies other than China have given between 15% and 23% CAGR returns; China has given a similar return over a 20-year period!
Fresh equity capital raised by corporates, which drives real GDP growth, was averaging about 1.1% of global GDP in the years preceding the Lehman crisis. After touching a low of 0.5% in 2008, it has recovered to about 1% in 2010. Gold consumption – inherently an unproductive investment – on the other hand has more than doubled relative to the global GDP. It is only a matter of time when inadequate investments in productive assets lead to shortage, which, in turn, would boost corporate profitability and generate handsome returns for investors who enter into equities at the current modest valuations.
Indian markets will, in the next few quarters, start looking at FY2013 earnings and by then inflation worries are likely to be behind us and earnings growth is expected to be a healthy 18.5%. With valuations also attractive, FII inflows may also increase again, considering that India, even more than China, is today arguably the emerging economy with the strongest long-term prospects.
The fundamental fact is that investing in equities over a longer period gives investors the highest compounded returns amongst all asset classes. This is because the economy inevitably marches forward and in the face of five years of 12%-14% nominal GDP growth, the equity markets also inevitably do go up. Then the one-month downside risk of 10%-15% due to inflation or fiscal deficit or myriad such noises just become irrelevant. Moreover, if you invest regularly, then you will be able to average out these gyrations and on a compounded basis, over the long-term you can generate significant returns from equities.
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