Stocks and Gold

The stock market's sentiment problem

The stock market has a sentiment problem because, despite the huge declines over the past 2 years in many of the high-profile stock indices, the public remains generally bullish on the market. This 'sentiment problem' is encapsulated by the following chart showing the net-position of small traders (a.k.a. the 'public' or the 'dumb money') in S&P500 futures contracts. This chart has dramatic implications.

The small traders - the ones who are most often wrong and who were, as a group, bearish on the market in early-1995 (just prior to a phenomenal 5-year rally) - have become progressively more bullish over the past 2 years as the market has fallen. We can't over-emphasise how unusual this is. Small traders, as a group, almost always become more bullish as prices rise and more bearish as prices fall. As such, they will tend to reach their maximum long position near major market tops and reach their maximum short position near major market bottoms. In other words, the net position of small traders in the stock-index futures market is a contrary indicator - when the small traders become very bullish it is usually a sign that the market is about to go down and when they become very bearish it is a sign that the market is about to rally. 

The main implication of the above chart is that we are still in the denial stage of this bear market (most people are still thinking in terms of the downturn in the stock market being a correction within a long-term bull market rather than a change in the long-term trend). This, in turn, means that the target of 800 for the S&P500 Index that we came up with at the beginning of this year is not even going to be in the same ballpark as the ultimate bear-market low. The S&P500 Index has already traded below 800 yet the general public still doesn't believe the long-term trend has changed. First of all the market will have to fall far enough to convince the majority of people that we are not just experiencing a correction within a long-term bull trend. Only then will the capitulation phase of the bear market begin. Unfortunately, based on what has happened over the past 6 months it appears that the capitulation phase won't even start until the S&P500 has fallen well below 800.

In summary, it is highly probable that the stock market is going MUCH lower, with the only question being when. Outside of gold and silver stocks an investor's exposure to the stock market should therefore be kept small in relation to their net worth. 

Gold versus the US Dollar

Like all investments or stores of value, gold's relative worth is determined by how attractive it appears to be compared to the alternatives. The alternatives to gold are the paper currencies of the world in general and the US$ in particular. The major influence on the gold price is therefore the level of confidence in the US$ and other paper currencies. Put another way, the investment demand for gold (and therefore the gold price) will languish when there is a high level of confidence that the US$ and the other currencies of the world will provide attractive real returns on investment. Conversely, the investment demand for gold will be strong when there is little confidence that the competing forms of money can provide a satisfactory return on investment.

The US$ is the linchpin of the world's current monetary system and, as such, it is gold's main competitor. As long as the US$ is perceived to be a strong currency there is little incentive for most people to invest in gold. However, when the US$ falls out of favour gold tends to come into favour. This is clearly illustrated by the following chart comparing the gold price and the Swiss Franc (SF). It is not coincidental that gold's current bull market can be traced back to October of 2000, the month that the SF made a long-term bottom against the US$ and embarked on a bull market of its own.

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