Gold price ratios and aggregate stock returns

Abstract

We show that most gold price ratios, which represent the relative valuations of gold, positively and significantly predict aggregate stock returns. These ratios fail to generate significant predictive ability after controlling for a series of return predictors described in Welch and Goyal (2008) or to display significant out-of-sample forecasting performance, except for the gold -oil price ratio (GO). GO is the most powerful predictor. A one-standard-deviation increase is associated with a 6.60% increase in the annual excess return for the next month. GO generates the most sizable out-of-sample R^2 and utility gains for a mean-variance investor. We find that the economic source of GO’s predictive ability originates from the cash flow channel using stock return decomposition and positive predictive power on economic conditions. The effect of GO is likely to be reversed only in periods when gold is valuable relative to oil, but the reversal is found to be insignificant. Return predictability from gold price ratios provides us with a new perspective for understanding gold price dynamics.