As Of: May 9, 2001

The Stock/Gold Ratio

Will the glitter leave stocks and return to gold?

      Two questions: 1) What is the useful value of one unit of the Standard & Poor's 500 Stock Index (a proportionate share of ownership in each of 500 major U.S. corporations)? 2) what is the useful value of one ounce of gold?

      It has probably escaped most people's attention that in the 1980's one ounce of gold was close to the same monetary value as the S&P 500 Index expressed in dollars. By the year 2000, the S&P 500 had risen to 5.5 times the price of gold. What do stocks have that caused them to become so valuable? And what has gold lost that has caused it to sink to less than 1/5th of its former relative worth?

      One thing that can be said in favor of gold is that, in addition to being an industrial metal and valued for jewelry, it is the only portable and fungible medium of exchange (substitute for currency) that does not depend on somebody's IOU. The value of every other national and international currency depends on the credit quality of the issuer.

      There are a lot of reasons why gold has lost its luster in the eyes of investors, not the least of which is the sale of gold by central banks. But the question of relative value remains. How should gold correlate to stocks? One could argue that a rising stock market is a sign of economic health. Economic health reflects strength in the country of origin, faith in its credit, and carries with it a strong currency as foreign investors convert to the local currency in order to purchase stock. Thus, in times of good health, one might expect that funds would flow out of weak markets and inert investments such as gold into a rising stock market. This would explain a relative shift in value favoring stocks over precious metals.

      The scenario of funds flowing into a nation with a healthy economy and a rising stock market begs the question, "How long can it last and how far can it go?" What happens when the health of the economy falters? The following chart displays the ratio of the Standard and Poor's 500 Index divided by the price of one ounce of gold. From approximate parity in the early 1990s, the value of stocks rose more than five fold until the market stuttered in 2000. As the health of the U.S. economy began to be questioned, one could predict that the price of gold might rise. As it turns out, the ratio dropped primarily because the stock market dropped while gold remained in a fairly narrow range.

      Of course it should be understood that the U.S. dollar has been sailing along at its highest level in 16 years. Thus, while the price of gold has been moribund when expressed in dollars, it has shown more life when expressed in other currencies. The U.S. dollar did go through a slight sinking spell when the markets faded, but both dollars and stock prices have regained some strength. The stock/gold ratio has climbed from a recent low of 4.25 on April 4^th, to a current level of about 4.75.

      The question of immediate interest is whether the stock/gold ratio is supported by tangible long term value, or whether it is supported primarily by faith. Is there a valid reason for the S&P 500 to be worth five times the price of an ounce of gold? Or will the stock/gold ratio sink back toward parity when faith diminishes in the U.S. dollar and stocks are seen as drawing rights on property of uncertain value.

      Whether gold rises or stocks drop, I am willing to bet that the spread will narrow.

Afterthought: With the Federal Reserve about to meet and probably lower interest rates again, what is the possibility that we get stagflation with a weak economy and rising prices due to a falling dollar? This might be the result if lower interest rates fail to stimulate the economy.