Below are extracts from a commentary posted at www.speculative-investor.com on17th October 2004.
The US Stock Market's Secular Trend
The secular trend in the stock market should be defined in terms of valuation rather than price. This is because it would, for example, be possible for the Dow Industrials Index to move higher during a secular bear trend if inflation caused a sufficiently-large reduction in the purchasing power of the US dollar. In such a case the Dow could trend higher in nominal dollar terms due to the boost to earnings and asset prices provided by a weakening dollar, but the average price/earnings ratio of the market would contract as would the real (inflation-adjusted) level of the Dow.
Further to the above, we think the best way to define the secular trend of the US stock market is in terms of the Dow/gold (or S&P500/gold) ratio because any long-term boost to the nominal level of the Dow from a weakening dollar would be offset by a rise in the gold price. Specifically, we consider a secular bull market to be a very long-term (10-25 year) upward trend in the Dow/gold ratio and a secular bear market to be a downward trend in the Dow/gold ratio lasting 10-25 years (*). The following monthly chart shows how these trends have played out over the past 75 years.
In our opinion the US stock market is presently about 5 years into a secular bear trend that should, if it follows the path of the previous two secular bears, take the Dow/gold ratio down to the bottom of the channel drawn on the above chart. This, in turn, would result in a Dow/gold ratio of around 5 assuming the bottom is reached within the coming 10 years.
Now, towards the end of the 1966-1982 secular bear market the Dow/gold ratio spiked well below the channel bottom, but this was due to the upside blow-off in the gold price during 1979-1980. Regardless of the cause of this downward spike, though, long-term investors who bought into the stock market when Dow/gold hit its channel bottom in 1974, who continued to buy all the dips in the stock market as long as Dow/gold remained within the bottom 30% of its channel and who then began scaling out during the rallies after Dow/gold moved into the top 20% of its channel, would have done extremely well (they would have achieved substantial REAL returns). On the other hand, long-term investors who purchase 'the market' with the Dow/gold ratio near current levels are almost guaranteed to achieve very poor REAL returns over the coming 10 years.
*It would also be appropriate to define the secular trend in terms of the market's price/earnings (P/E) ratio with a long-term upward trend in the P/E ratio being the hallmark of a secular bull market and a long-term downward trend in the P/E ratio being the dominant characteristic of a secular bear market. However, we prefer to use Dow/gold because the gold price is a known quantity whereas the "E" in the P/E ratio is an accounting estimate and is therefore open to interpretation.
Gold: the big picture
During a secular gold bull market gold moves higher in terms of all major fiat currencies due to declining confidence in government and financial assets throughout the world. In this important respect the 1999-2004 rally in the gold price has the characteristics of a secular bull market.
To help illustrate the above point we've included, below, a long-term chart of the gold price in terms of the Swiss Franc. The Swiss Franc has been one of the world's strongest currencies over the past 34 years, so for the purpose of this discussion it is a good currency to use (when gold is trending higher in terms of the strongest currencies it will, of course, also be trending higher in terms of the weakest currencies). The chart shows that:
a) Gold has trended higher in SF terms over the past 5 years
b) Gold did NOT trend higher in SF terms during 1985-1987, indicating that the 1985-1987 gold rally was a cyclical bull market within a secular bear market (it was a counter-trend move)
c) Gold trended higher in SF terms throughout the 1970s
With reference to the above chart it is interesting to note that the slope of the upward trend over the past 5 years is almost identical to the slope of the upward trend during the 1970s. However, what we haven't yet seen during the current bull market is a period when the gold price accelerates up and away from the long-term trend-line, whereas during the 1970s there were two such periods (shown in red boxes on the chart).
Although the first half of this year was a likely TIME for an important peak in the gold price, the complete absence of trend acceleration up until now suggests to us that we haven't yet reached the point where a major downturn is probable. Instead, we think there will be a very sharp rally in the gold price in terms of all currencies -- either over the coming two months or during 2005 -- before a major correction gets underway.
