This obscure indicator with an impressive record has a bullish message for the stock market

By Mark Hulbert

As the ratio rises, the shorter-term outlook for equities gets better and better.

The stock market is poised to produce a double digit return over the next year.

That's the prediction of an obscure indicator with an impressive record of forecasting the stock market's subsequent 12-months return: The gold-platinum ratio. As the ratio rises, as it has recently, the shorter-term outlook for equities gets better and better.

This bullish news doesn't change the stock market's poor longer-term prospects; as I discussed a couple of weeks ago, equities will be lucky to simply keep up with inflation over the next decade. But, like a leaf in hurricane, which we know will eventually fall to earth, it can soar over the shorter term. And this is not unlikely, according to the gold-platinum ratio.

I first learned about the gold-platinum ratio from Darien Huang, a former finance professor at Cornell University, and Mete Kilic, a finance professor at the University of Southern California. Their 2019 study, titled "Gold, Platinum and Expected Stock Returns," appeared in the Journal of Financial Economics. They found that the stock market more often than not rises over the subsequent 12 months when the gold-platinum ratio is in a strong uptrend - and vice versa.

Specifically, the professors reported that the ratio is a "strong, robust predictor of aggregate stock market returns" which "outperforms existing predictors." I last wrote about the ratio in early February, at which point it was projecting a 12-month return of 15%. Since then the S&P 500 SPX has gained 18.1% on a total-return basis.

The accompanying chart illustrates the strong correlation between the gold-platinum ratio and the stock market. The correlation is very significant at traditional standards of statistical significance.

To translate this historical correlation into a stock market forecast, I segregated the gold-platinum ratio over the last 20 years into four equal-sized groups, based on its trailing 12-month rate of change. The table below reports the stock market's average subsequent 12-month total return for each of these quartiles.

   Broad stock market's average return over subsequent 12 months 
   25% of days since 2004 in which gold-platinum ratio's 12-month ratio of change is smallest  6.5% 
   Next highest 25% of days                                                                    8.1% 
   Next highest 25% of days                                                                    10.8% 
   25% of days since 2004 in which gold-platinum ratio's 12-month rate of change is greatest   20.1% 

This helps us understand why the gold-platinum's ratio is telling such a bullish story right now: Its rate of change over the last 12 months is solidly in the highest quartile.

Why the gold-platinum ratio is a good predictor

The reason the gold-platinum ratio is a good predictor, according to the professors, is that it is a sensitive proxy for geopolitical risk. While both gold and platinum have industrial uses, and therefore respond to changes in the economy's growth prospects, gold is far more sensitive than platinum to perceived changes in geopolitical risk. A rising ratio therefore means geopolitical risk is increasing, independently of economic risk.

The professors' theory isn't that the stock market likes increasing geopolitical risk. They acknowledge that the stock market will tend to suffer as that risk rises. Their point is that equities' future prospects will tend to expand when risk is rising, since stocks should recover their lost ground when that geopolitical risk is reduced.

This helps us make sense of the stock market's recent strength, which has come in the wake of a rising gold-platinum ratio. The professors' theory is that the stock market would have been even stronger over the recent past if it hadn't been for the heightened risk being detected by the ratio. Some of this forgone performance has been transferred into the stock market's future.

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.

-Mark Hulbert

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10-01-24 0654ET

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