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The Bullion Report

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January 12, 2011 in 'The Bullion Report'

Dow vs GoldDow vs Gold

Plenty of indicators try to bring the world of gold to an investor’s doorstep, and in a bullish environment they all seem to make headlines. The Dow/Gold ratio is one of those headline-making numbers that warrants a closer look. What exactly is this ratio and what is everyone watching for?

Past performance is not indicative of future results.

***chart courtesy Stockcharts.com

The Dow to Gold ratio is a simple expression of how much gold it takes to buy one share of the Dow. It shows the ratio of the Dow price to gold price. For some analysts this is a good indicator of the strength in equities. It is also seen as a representation of a potentially cyclical battle between paper money and precious metals as money. If gold is seen as an unbiased form of money, then the Dow/Gold ratio is viewed as a representation of the “real” value of equities.

The really interesting thing about the Dow/Gold ratio becomes apparent when you look at a long term chart of the relationship. The key moments in market history are marked by a climb in the Dow/Gold ratio and then a tumble afterwards. The boom of the twenties brought a 20:1 ratio that collapsed during the Great Depression. Following the two World Wars, the ratio saw another gradual expansion that actually peaked above 20:1. This was brought low again until the 1980s saw the foothold of another climb higher.

Past performance is not indicative of future results.

***chart courtesy thumbcharts.com

In the most recent bullish market environment, this ratio was above 40:1. That meant that it would take 40 ounces of gold to purchase a share of the Dow. This peak could be viewed as a good indicator of just how out of whack things could have been during the dot-com bubble. Following the historic pop, the ratio contracted again. It has been flagging ever since. Right now the ratio is just above 8:1, with a climate of fear-induced interest in gold purchases and a great deal of uncertainty in other investments. So what can be gleaned from this current Dow to Gold price ratio?

For some analysts, the really fascinating moments are when the Dow is rising but the ratio is dropping. To them, this signals a “false” value for equities. They cite the primary motivating factor as the inflation spurred by free running of the printing presses. This might stimulate the markets short term, easing credit issues and trying to inspire investors, but the long term it might be a risk for inflation. It is seen as a false flag for investment in stocks, an overall weakness that is illustrated by the smaller ratio despite higher stock prices. So what is the possible outcome?

The nature of this ratio is that it has historically bottomed out somewhere well below where it currently sits. This means that there are a few things that may happen to bring about a 1:1 situation, including the following scenarios:

-          The price of gold could rise while the Dow falls

-          The price of equities can drop AND the price of gold could drop, but the Dow would plummet faster

-          The price of gold and the Dow could gain, but gold could add gains much faster

So in this current environment, that could mean investment demand for gold and a gain in gold prices. With the twin threats of economic uncertainty and risk of inflation as the dollar is devalued, it seems likely that gold will gain faster than the Dow, shrinking the Dow/Gold ratio.

Summary

The Dow/Gold ratio matters to gold investors because it illustrates a salient point about gold as money. Each time there has been an apparent breakdown of the monetary system, gold has emerged as the go-to substitute for wealth preservation.  It may be difficult to pinpoint exactly when and how the 1:1 Dow/Gold ratio will be met, but in the current climate it seems reasonable to look to gold as a means of asset preservation. As long as there is a risk that the US dollar, and even the Euro, are being printed and weakened, there is a likely basis for an argument for higher gold prices.

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 “What I’ve been predicting is that the relationship between gold and the Dow will be 1:1…..That could be gold $5,000, Dow 5,000. It could be gold $10,000, Dow 10,000. I don’t know, but I think those two numbers are going to get very close to one another.” Peter Schiff, Fast Money Interview 2010


Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.