March 26th, 2011
Recently, in “The Gold Value of Commodities“, I theorized that, based on relative prices going back to 2006, “….there has been a bubble in precious metals [since 2008], one that has to return to a more realistic relationship with other hard and soft commodities.” A reader asked whether I had comparable data going back 40-50 years? I promised I would do some research and come back with what I had found.
What I found surprised me as I think it might you, too.
One would assume that there’s reversion to the mean at work when it comes to the relationship between the price of gold and of the stock market. International financial liquidity and money flows could drive prices of metals or financial instruments temporarily out of kilter with one another but, over the long run, these prices will tend to revert back to some sort of mean relationship.
We see that happening across markets all the time:
- High industrial metals prices acts as a brake on demand and those prices will adjust back into line.
- A declining Dollar makes US stocks relatively more attractive to foreign buyers driving new demand pushing both the Dollar and stocks higher.
- Stock prices will rise until fixed income securities begin to look attractive on a risk/reward basis. Conversely, money will flow from fixed income investments driving down their prices when interest rates become too low relative inflation or the returns available in stocks.
A similar long run relationship exists between the average value of stocks (as measured by the S&P 500 Index) and the price of gold. This relationship (the ratio of SP500 divided by the price of Gold in $US) has fluctuated in a wide range since the US first went off the gold standard in 1971. At the end of January 1971, gold cost $37.88/oz while the S&P 500 Index closed at 95.88 for a ratio of .395. Since then, the ratio has fluctuated in three long-term trends with an extreme high of 5.98 in 1980 (at the end of the 1970’s oil embargo, secular bear market and astronomical interest rates) to an extreme low of 0.18 (at bursting of the Tech Bubble in 2000) (click on image to enlarge):
The ratio is now almost exactly in the middle of that range (when measured on a logarithmic scale measuring percentage changes) with the S&P 500 (1372.73) and gold (1327.22), nearly at parity (1.034) on Feb 28. The big question is where the ratio might be headed over the next 5-10 years. Will the ratio continue its current long-term trend higher climbing back to 4-6 range or might it now reverse and begin a slow, long-term descent to the .2-.3 range?
The ratio is a function of both variables, the price of gold and the value of the 500 largest US public companies. Both variables are equally driven by value of the $US, domestic and international economic trends and a host of other drivers. Alternative possibilities for the ratio are possible through almost an infinite number of combinations of both variables as follows (click on image to enlarge):
Some gold bugs claim that the price of gold is headed to the $4000/ounce level without indicating what they think will happen to the stock market. That doesn’t work for me.
Make your own guess as to where and when you think the price of gold will be. But you should also forecast where you think the S&P 500 might be at the same time. It’s only after you calculate their ratio and see where it plots on the above chart will you be able to assess the reasonableness of those projections.
Once a long-term trend begins it’s hard to reverse. I can accept $4000 gold and the S&P hits 2000 (a 50% increase from current levels) for a ratio 2.0 in 2014.