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The stock market falls when risk rises, but once the market has adjusted to that higher risk, the market’s expected future return improves substantially. That’s the theory. But how do you make this work for your stock investments?
One answer was provided last summer in the prestigious Journal of Financial Economics, in a study by Darien Huang, a former finance professor at Cornell University, and Mete Kilic, a finance professor at UCLA. They found great promise in using the ratio of gold’s price to platinum’s. Increases in that ratio mean that the stock market’s expected future return is higher, and vice versa.
The ratio is a sensitive measure of risk because gold GC00, -1.40% responds to different factors than does platinum. The price of platinum primarily reflects changes in industrial demand, while gold responds both to that as well as investor demand for a safe haven asset. Therefore, as Kilic put it to me in a recent email, the gold-platinum ratio “isolates the component of the gold price that is driven by gold’s role as a safe asset from its pro-cyclical component as a consumption good.”
A rising ratio means investors believe market risk is rising. To compensate, equities must deliver a higher-than-average expected return. Other things being equal, that means the stock market will fall (or rise at a slower rate) but have a higher expected future return.
The professors found that this ratio does a decent job forecasting the market’s return over the subsequent 12 months. That’s good news for the stock market’s prospects over the next year, since — as the accompanying chart shows — the gold-platinum ratio skyrocketed over the two months between late February and late April. According to this econometric model, the increase means that the market’s expected return is more than 12% higher than it was in mid-February.
To be sure, the model failed to signal the recent bear market. As you can see from the chart, the ratio did decline from last summer to January, but that decline translated into a reduction in 12-month expected return of just 5% or so.
Overall, the ratio has an enviable track record, according to the researchers. They found that, since 1975, the gold-platinum ratio has had a significantly better track record when predicting the stock market’s subsequent one-year return than nine other well-known indicators that researchers previously found to have predictive ability — such as price/earnings ratio, price/sales ratio, and price/book ratio.
Keep in mind that the increase in the stock market’s expected return over the next 12 months is not a free lunch. The increase corresponds to the heightened risk in the market — more sleepless nights, in other words.
This is the theoretical underpinning to the Baron Rothschild’s famous line that the time to buy is when the blood is running in the streets. It is unrealistic to expect well-above-average stock market returns while also sleeping soundly.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
