Monday, July 16, 2012

Three Graphs Explaining When to Dump Gold and Buy Stocks

To break up the doom and gloom of today's markets and economy I want to focus on the future. At some point in the future, the gold trade will come to an end, the great Keynesian experiment will end and the markets will be forced to reset once central bank manipulations fail to kick the can down the road a little further.

Just as this will likely mean the peak in gold and a new currency regime, it will also open up new opportunities in the investment world. And in order to be ready for that time you must know what to look for in order to recognize it. This point will likely be a once in a life time chance to buy stocks very cheaply and set you up for the next twenty years to follow.

There are three graphs that show the cyclical patterns that lead to long term equity bull markets.

The first graph below shows the Dow/ Gold ratio. As Gold goes up or the Dow goes down, the ratio decreases. Though this graph only shows up to 2009, today the ration is about 8, virtually unchanged. This is primarily due to the temporary affects of QE1, QE2 and Operation Twist- all Fed operations to stimulate the economy by increasing the money supply. This has artificially increased the Dow even as Gold has leveled off the last year due to Europe's problems that have made dollar assets relatively more attractive that Euro assets. The trend, however will almost certainly continue as the USD as safe haven is merely transitory and the value of gold will increase due to buying by non western central banks and possibly by the BIS (Bank of International Settlements) making gold a Tier 1 asset.

When the Dow/Gold ration approaches 1, it will be time to transition from physical gold holdings to stocks, that is selling gold at a high and buying stocks at a low. Of course this will hopefully be in the context of a financial system that is more stable and strong oversight from a renewed SEC that prevents more MF Globals and rehypothecating theft.

The second graph below shows the S&P 500;s variation around the mean (average). As you can see below, the index dropped to its long term mean during the financial crisis, but just briefly, before bouncing back up on QE enacted by the Fed. You can see below there were several times the S&P 500 dropped well below its mean in 1920, 1932 & 1982. We should expect to see another significant drop below the mean before another long term bull market in stocks can resume.

You'll notice above that the market hit the mean return in the "teen years" before dropping through and hitting its bottom in 1920. These were tests of the long term support levels. The market hit this support level twice before falling through the mean. I believe the 2009 decline is a similar test of the support level and we may see another test of support off the mean before a major drop through.

The the first graph used the Dow as its relative index and the second used the S&P 500, they essentially both measure the US stock market. Both represent a need for the US market to drop in order for the market to revert to the mean and have the Dow/Gold ratio to decline.

 In the third and final graph below we can see the S&P 500 Price to Earnings ration relative to the S&P 500's dividend yield. From Grant Williams we get the data that:

The 1982 bull market began with the S&P 500 trading at 7X earnings and yielding 6.3% (Green dotted line left). It ended in the tech blow off at 30X earnings at 1% yield (red dotted line, left. As we stand today, the S&P 500 is yielding 2.5% and is trading at roughly 11X earnings (blue line left)

As you can see, the PE ration and Dividend yields of the S&P 500 move in the opposite direction. This makes sense since higher stock prices result in a lower yield at any given dividend.

The important point though is that you can see that the yield (brown line) is once again crossing the PE line (purple line) on the far right side of the graph just as it did in the early 1970's on the left side of the graph. Following the historical oscillation of the two we should expect lower PE ratios going forward and higher yields on stocks. The two lines should continue to diverge as they did in the 1970's setting up the buying opportunity of a generation. Will it take another eight years from this point as it did back then? Possibly.

But I expect that its more likely that we have been setting up events since 2008 where all three of these graphs will meet their targets together in what may be a perfect storm that happens abruptly. When its does, whether it takes one year or ten, it will mean that a transition is underway.

Until then, keep stacking gold and silver.

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