Dow to Gold Ratio

What could be more appropriate to kick things off than the famed Dow to Gold ratio? This is the chart that opened my eyes to gold, and this is one case where one picture says it all.

What does it mean? Right now the ratio is about 18, which means that one basket of the Dow Jones Industrial Average is about 18x the price of one ounce of Gold. Alternatively, it takes 18 oz of Gold to buy one basket of the Dow. At the two most recent bottoms hit in the 20th century, the ratio was close to 1, which means that one basket of the Dow cost one ounce of Gold. At the peak of the dotcom stock bubble, the ratio was over 40, which means that one basket of the Dow cost 40 ounces of Gold. Currently, the ratio is in what appears to be a long secular downtrend, in the direction of the arrow.

When I first saw this chart back in 2003, I was knocked out by the raw power of the cycles. Huge mega secular cycles lasting decades, taking the D/G ratio from one extreme to the other. We all know the saying "the trend is your friend", and this is one mega trend which potentially could be the mother of all investment themes.

Even without delving into the whole topic of gold vs fiat money (a very important topic which I'll save for another day), it should be pretty apparent that we are now in the middle of a long-term secular downtrend in the ratio - perhaps heading down to those depths reached twice before in the last century. That means that the nominal price of the Dow Jones Industrial Average must fall, relative to the nominal price of an ounce of Gold -- or, if you prefer, that the purchasing power and nominal price of Gold must rise relative to the Dow. If history is any guide, based on the two times it's happened since 1929, we will eventually see the ratio approach 1.0 again, at which point the Dow (i.e. stocks in general) will be dirt cheap compared to Gold. Can you imagine one ounce of gold buying one Dow basket? That translates into $12000/oz gold or $600 Dow!

But the D/G ratio can fall because of two reasons: decline of Dow or rise of Gold. Simply going short stocks or long gold isn't guaranteed to be a winning bet at all - certainly not in the short term anyway. The main thing to realize is that the ratio is a relative value indicator... so that means the ideal way to play this trend is a relative value trade. To be exact, short stocks *AND* long gold in the same trade. Unfortunately, there's noplace where a retail investor can net off these positions, so such a trade is likely to be capital intensive.

In any event, we may wonder where this great convergence will happen... at what price level will the Dow Jones Industrial Average be equal to the price of 1 oz of Gold? Richard Russell says somewhere around $3500 - that sounds good to me. Some hardcore gold/silverbugs think Gold will rise well above $10000 - I'm not really sure about that though. Deflationists think the Dow will crash to below 2000 points - that seems too depressing to be likely. Personally, I think we may well see a hyperinflation phase over the next 10-15 years to take the Dow up to 20000 or beyond, and THEN we'll see the big deflationary bust which will bring Dow back to the sub-5000 area - and that could also be where we see Gold end up.

Last thought: the Dow to Gold ratio is exotic. Probably so exotic that most investors can't get a grip on the implications. Obviously, the chart says it all -- but a discussion of the factors underlying the secular trend could take ages. What we should recognize now is that stocks are losing value relative to real money (gold and silver), and we have a long way to go in this trend. History may not repeat, but it rhymes - and we'd be unwise to think that this time it's any different!