Stock Market Sentiment and Gold Market Manipulation

Here is a slightly-modified extract from commentary that was posted at www.speculative-investor.com on 11th August 2002.

Stock market sentiment and PE ratios

In past commentaries we have discussed why looking at the PE ratio of the overall stock market is not a good way to assess whether the market is cheap or expensive and therefore whether the market is near a peak or a bottom. In particular, the 'PE ratio' becomes useless as an indicator for the overall market, or for any stock index, during a period when there is a sharp decline in profits. The early-1930s was such a period and, unfortunately, we are presently in the midst of such a period. Corporate America, as a whole, made a loss in 1932 and therefore PE ratios were approaching infinity as the stock market approached its major bottom. A similar situation appears to be evolving right now.

High PE ratios are not, in themselves, a major problem for the stock market and do not preclude the market from being near a long-term bottom. As discussed above, when the market does eventually bottom the average PE ratio could well be even higher than it is today due to collapsing profits. What is a major problem is that we are still at that psychological place where investors are quite happy to pay the high PE ratios in the belief that earnings are going to surge over the next 12 months. In other words, there is a strong undercurrent of optimism regarding the future performance of the economy and this optimism is built into stock prices.

Why do we think that today's high PE ratios are a sign of overly-optimistic investor sentiment rather than just the natural end result of a crash in profits? One reason is the extremely bullish posture of small traders in S&P500 futures that we've discussed at length in the past. Another reason is the pervasive belief that stocks are now cheap and that they will turn out to be great investments if bought today with the aim of holding for the long-term (this will not be the majority view when the final bottom is reached). A third reason is that the majority of investors don't care about dividends. The dividend yield of the S&P500 Index is presently only 1.73%, about 3.4% less than the yield on a T-Bond. The fact that the average investor is prepared to accept a dividend yield that is substantially below the 'risk free yield' means that he/she is very confident that the total return on stocks (dividends + capital gains) is going to be much higher than the bond yield over the next few years. Once again, this is absolutely not the attitude we would expect to see if the market was near a major bottom. 

Gold market manipulation

Based on what we've witnessed over the past 10 years we are very confident that governments (including the US Government) and their central banks try to manipulate the price of gold. The exact nature of the manipulation is unknown, but nothing would surprise us. However, we devote almost no space in our commentaries to the manipulation of the gold market and do not consider it when doing our own trading/investing. The reason is that the relationships between gold and other markets that have worked well since gold and the dollar were officially de-coupled in 1971 are still working today.

One of the most important relationships is the inverse correlation between gold and the US$, or, as we prefer to look at it, the positive correlation between gold and the Swiss Franc. The following table shows the correlation coefficient between gold and the SF-US$ exchange rate (the number of US Dollars per Swiss Franc) over various time periods. Markets that are not correlated at all will have a correlation coefficient of zero, while markets that always trend in the same direction will have a correlation coefficient close to 1 and markets that always trend in opposite directions will have a correlation coefficient close to -1. Note that a high positive correlation between two markets does not indicate that the markets will move in the same direction almost every day. It indicates that the markets have a strong tendency to be near the tops of their respective ranges at the same time and near the bottoms of their ranges at the same time.
 

Over the period from 1973 to the present day the SF and the gold price have had a positive correlation of 0.79. This is extremely high (it is rare for two different markets to have such a high correlation). Manipulation of the gold market supposedly slipped into top gear in 1995, yet the positive correlation between the SF and gold since January-1995 has been 0.89 (even higher than the already-high long-term average). In fact, the only period over the past 30 years when the correlation was higher was 1985-1989. The lowest correlation occurred during 1990-1994, perhaps because the dollar was not trending strongly during this period. Since the beginning of 2000 the correlation has been 0.68, below the long-term average but still very high.

Note that the positive correlation between gold and the SF is much greater than the inverse correlation between gold and the Dollar Index. For example, as mentioned above the correlation between gold and the SF has been 0.68 since the beginning of 2000. However, over the same period the correlation between gold and the Dollar Index has been -0.30. 

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