What the Dow/Gold Ratio Can Tell Us

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Stock prices climb higher over the long term — that is essentially a given. But while stock prices climb higher so do the prices of virtually everything else. So if stock prices are climbing higher and the prices of the things we need to buy are moving higher, how do we know whether or not we are growing our purchasing power when we own stocks? Sure the Dow Jones has climbed from a few hundred points to  more than 10,000 points in the past 75 or 80 years, but so has the price of, say, a car.

One way is to look at stock prices in terms of the price of gold. While the supply of dollars is constantly rising at a fairly rapid pace, the supply of gold rises at a much slower pace. Since nearly all of the gold that has ever been mined is still around, a year’s worth of gold production does very little to the overall supply.

By measuring stocks in terms of gold we can better understand whether it is a good time to own stocks or not. When I say that it is a good time to own stocks, I don’t mean that you should own only stocks, or when I say that it is a bad time to own stocks, I don’t mean that you shouldn’t own any stocks. But if you have an idea of how stocks in the aggregate are valued relative to gold, as measured by the Dow Jones Industrial Average for the sake of simplicity, your investments will perform much better.

If you look at the performance of the Dow in terms of gold in the long run, a different picture emerges. Rather than seeing ever-rising prices, we see cyclical behavior. The Dow rises relative to gold and then it falls relative to gold, and it stays relatively range-bound with some exceptions.

In 1929, when the stock market peaked, the Dow traded at 18-times gold. When the low was hit in 1932, the Dow traded at twice the gold price. Then stocks began to rise again, peaking at about 18-times the gold price. Then a prolonged bear market began, which saw a bottom when gold and the Dow traded at a 1 to 1 ratio. Then a tremendous bull market took the Dow to nearly 45-times the price of gold in 2000.

Since then, the Dow has been declining in terms of gold. While this trend has reversed in the past couple of years, historically, it seems that we have yet to reach a bottom in the Dow/gold ratio. This low point has been at 2 to 1, or even 1 to 1 in 1980. If history repeats itself, either the Dow has a long way to fall or gold is going to soar, or some combination of both.

One further implication from the historical data is that when the Dow/gold ratio bottoms out next time that it should be at a lower level than the two previous lows. When markets correct they tend to overcorrect, and the higher the rises in an asset the harder the fall. Thus in 1929, the Dow/gold ratio hit just 18, and so it bottomed at 2. When it rose higher, to 28 in 1965, it wound up falling to just 1.

Since it hit a new high of 45, the pattern would indicate that the correction should be even steeper than the previous two. This means that gold would trade at a higher price than the Dow, and this phenomenon would be a signal that it is time to sell gold and to buy stocks.

While there is no guarantee of this happening, the pattern is fairly predictable. Furthermore, the pattern clearly shows bull and bear markets in stocks, whereas a look at the Dow in dollar terms simply shows an ever-rising market with a sharp correction here and there. It fails to show that while stocks didn’t really fall in the 1970s, they lost purchasing power, and that holding stocks was a lousy proposition.

Investors who see this pattern and accept its predictions shouldn’t immediately sell all of their stocks. There are several stocks worth holding, including Dow components. But it probably is a good idea to build a core position in gold and related equities especially now that these assets have corrected over the past couple of years. I think that the investors who do will be very happy they did, and they will be well-positioned to buy stocks when pessimism finally peaks in the years ahead.

Disclosure:  Ben Kramer-Miller is long gold coins and select gold mining shares.

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