Why It's Important To Watch The Stock/Gold Ratio

The relationship between Stocks and Gold

• Long-term Picture
• Three interpretive rules
• Looking at it the other way. The Gold/stock Ratio
• Two Politically troubled ETF’s, are so technically troubled

Long-term Picture

One of the areas I focused on in my latest Market Roundup Webinar was the tight trading range in the relationship between stocks and gold. I covered it in detail because this ratio appears to have reached a crucial juncture point, with important implications for both components.

Chart 1 features the ratio, calculated by dividing the S&P Composite by the monthly gold price, together with its long-term KST. When it is in a rising trend it means that stocks are out-performing gold and vice versa. I have also placed arrows at the main KST turning points. The solid ones flag periods when it has also been possible to construct a trendline for the ratio and that trendline has been violated. The dashed arrows indicate KST turning points where it was not possible to construct a trendline. The 2003 situation was unique, in that it a down trendline could be drawn, but instead of the usual rally following its penetration, it went sideways for a year or so.

Since mid-2015, this relationship has found resistance at the 2006-17 down trendline. However, October’s action suggests that a breakout in favor of stocks is in the process of taking place. We have to be a bit careful on this one, because the chart has been constructed from month-end closes and we are only in the first part of the month. That means that a valid plot for October will not actually take place until October 31, the last trading day of the month. However, the fact that the ratio has been above its 12-month MA for a while, and the KST is in a rising mode, argues in favor of the current breakout being maintained at month-end.

Chart 1

Three interpretive rules

That’s important because a decisive monthly close above the green trendline has some serious consequences for stocks in their own right. Chart 2 reflects these implications, established from the following three rules from trends in the ratio.

1. If stocks under-perform gold they are at their most vulnerable.
2. Alternatively, if stocks under-perform gold they sometimes experience a modest rally.
3. If stocks out-perform gold they invariably rally in their own right.

The pink shaded areas flag periods when the trend of the ratio is in a clear-cut negative mode, meaning that gold is out-performing gold. In that kind of environment stocks are at their most vulnerable, as we see two bear markets unfold, those of 2000-2002 and 2007-09. The gray shadings also show weakening trends in this relationship, but they are less severe. In this respect, the thick dashed blue arrows point out that a falling ratio is not necessarily bearish for stocks. Finally, when the ratio’s trend is in a clearly positive mode, as reflected by the unshaded periods, stocks are free to rally more sharply. That means that if the ratio can break decisively to the upside in the period ahead, we should expect to see a very strong equity market. Remember, that green 2006-17 down trendline is very significant since it is a long one and has been touched or approached on numerous occasions. That suggests that its successful penetration would propel both it and the S&P substantially higher.

Chart 2

Chart 3 shows the picture using Friday closes of the ratio. In this instance, a breakout has not yet materialized, as this relationship remains below its 2015-17 resistance trendline. Two factors suggest that it soon will surpass the line. First, the ratio recently experienced a false break to the downside, as it temporarily breeched both trendlines and the 65-week EMA. Whipsaw moves such as this, are typically followed by above average moves in the opposite direction to the false break. That usually happens, because bearish traders, who shorted on the break, are forced to cover those positions, as the trend moves against them. Second, the short-term KST is in a bullish mode and is by no means overextended on the upside. After all, it is only just crossing through the equilibrium level.

Chart 3

Looking at it the other way. The Gold/stock Ratio

We can also turn this upside down and see what happens to the absolute price of gold when the ratio is rising or falling. In Chart 4 therefore, a rising ratio means that gold is out-performing the S&P Composite, and vice versa. The pink shadings tell us when this relationship is in a strong downtrend, Basically speaking, this is bearish for gold. The gray shading tells us when the ratio is in an anemic or sideways trend. Usually this means that gold is in a small uptrend. The unshaded areas point up when the ratio is in a strong uptrend. In these instances, so too is gold. We have already established that an upside break in the stock/gold ratio is bullish for stocks in their own right. Chart 4 suggests that a downside break in the gold/stock ratio, if confirmed by a similar break in the gold price, with a monthly close below $1175, will signal a major decline for the price of the yellow metal itself.

Chart 4

Two Politically troubled ETF’s, are so technically troubled

Spain, with its Catalan separatists, and South Korea, with its unfriendly neighbor to the north, are two political hotspots that have had every excuse to sell off. However, the MSCI Spain ETF (EWP) recently completed a head and shoulders top, but on Wednesday came right back to the breakdown area. That may turn out to be a whipsaw, which would be very bullish. However, in order for this to be so, the price needs to confirm by moving above the green down trendline at just under $34.

Chart 5

South Korea, in the form of the MSCI Korean Capped ETF, the EWY, broke down briefly in August and has been zig zagging upwards ever since. On Wednesday in late- afternoon trading, it had managed to remain above the green resistance trendline. All of this suggests that this ETF is headed higher as it rises on its North Korean wall of worry.

Chart 6

Remember, markets that shrug off bad news are usually very healthy. If we get confirmation from both of these two politically troubled ETF’s that will not only be bullish for the EWP and EWY but global equities in general.

Good luck and good charting

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.