Stocks surge relative to gold

In a previous post on the subject of gold re-linking to commodities, I mentioned in passing something that Larry Kudlow reminded me of recently: the last time gold suffered such a huge drop (January 1980) was 2 1/2 years before the economic and stock market boom of the 1980s got underway. Lots of things are different this time around, of course, but it's an idea worth fleshing out.

The first chart above shows the ratio of monthly spot gold prices to the S&P 500 (just the index, not including reinvested dividends) over the past 85 years, while the second chart shows the ratio of daily prices over the past five years. As should be obvious, we have just seen a significant change in the relative strength of stocks and gold. Stocks appear to be on the cusp of a new trend, rising in terms of gold, and this could portend optimistic tidings.

Over the time period of the first chart, there have been only two episodes in which stocks strongly outperformed gold over a sustained period: the first, from around 1950 to around 1965, and the second, from late 1982 through 2000. In the first period, real GDP grew at an annualized rate of 4.5%, which is substantially more than the the 3.1% long-term average growth rate of the U.S. economy. In the second period, real GDP grew at an annualized rate of 3.7%, well above average. Real GDP growth was below average in the periods during which stocks fell relative to gold, the worst being from 2000 through 2012, when real GDP growth was an annualized 1.6%.

Of course, changes in the ratio of stocks to gold aren't what drives economic growth. Rather, it is strong economic growth that drives stocks higher relative to gold. During periods of healthy growth investors naturally gravitate to equities at the expense of gold, because profits are rising, stocks pay dividends, and gold yields nothing. When growth is weak, uncertainties typically abound, profits are squeezed, and gold gets the nod in favor of equities because speculation tends to supplant investment.

The upturn in stocks is thus a preliminary indicator that the economic fundamentals may be shifting in favor of equities, and that, in turn, would suggest that the long-term outlook for the economy is improving. Probably not immediately, but some time in the next few years we could see some genuine improvement in the economic fundamentals. Markets are always forward looking, and this indicator (the ratio of stocks to gold) could be one of the most forward-looking of all. Let's hope so.