Declining Stock Markets & Gold

The U.S. has had almost two decades of low inflation and relatively low interest rates, which have had a predictable impact on the stock and bond markets. As interest rates fall, investors move out of short-term investments like CD's and T-Bills, and put money in the stock and bond markets where returns are higher. As it becomes cheaper to borrow money, consumers buy more on credit and companies implement expansion plans. The economy expands, companies do more business, profits rise and stock values increase. Eventually, the result is a raging bull market in stocks, just as we have seen in recent years.

All good things eventually come to an end. As the stock market continues to Fall from recent record levels, investors should begin to think about the future:

Can stock values be sustained at levels that put price-earnings ratios in the stratosphere?

Can companies with no earnings continue to experience rocketing growth in their share prices?

If Alan Greenspan is worried about the inflation in the economy's pipeline, should you and other investors be worried also?

If traditional valuation measures for stocks were to return to historical averages, prices would decline by anywhere from 35% to 60%. If the time-honored economic concept of reversion to the mean still has any significance, then investors should buy some insurance for the huge, unrealized profits that they now have in U.S. stocks.

The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. Gold is the ideal diversifier for an equity portfolio, simply because it is the most negatively correlated asset to equities.

The reason for gold's negative correlation to stocks is that the economic and financial forces that determine the price of gold are vastly different from those that determine the price of stocks. The value of a stock depends on a company's earnings and growth projections. The value of a company's debt instruments depends on their safety and yield. The value of gold, on the other hand, depends on factors such as political and economic unrest, currency fluctuations and inflationary expectations. Almost universally, those factors that boost the gold price serve to depress the price of equities.

Many stock market analysts and investors seem to believe that volatility is good because its only effect is to make stocks cheaper and, thus, more attractive. But bull markets do end and bear markets do happen. Evidently, that would be a rude awakening for many investors.

Since 1956, nine downturns are generally regarded to have been bear markets (with declines of 20% or more in the Dow). That means bear markets have occurred, on average, about once every five years. The average duration was 12 months - ranging from as short as two months to as long as nearly two years.

Keep in mind that the last bear market occurred ten years ago, barely qualified as a bear market with a decline of 21%, and lasted only three months. We are overdue for another bear market and an entire generation of investors and Wall Street money managers have never experienced a severe bear market. Investors should be prepared.