Saturday, October 4, 2008

The Dow to Gold ratio - the aha! moment

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This my first rant. My goal is to catalog things that are important to my understanding of the financial world and bring a few others along for the education and interaction

Like many, I was taught/believed everything WRONG when it came to managing money and asset allocation in terms of investing. "Hold for the long term," "dollar cost average into stocks," etc., etc.

Of course, it's all bullshit. No one cares about you or your money more than you should. No, money is not the most important thing in life, but there's nothing wrong with taking care of your money just like your apartment, house, or car.

When it comes to understanding the macro environment, nothing made it clearer for me than a Dow to Gold ratio chart. The chart below compares the price of the Dow Jones Industrial Average to the price of one ounce of Gold in U.S. Dollars. In other words, if the Dow Jones is at 10,000 and the price of Gold is $1000/ounce, the Dow:Gold ratio is 10.

Let's take a look over a long period of time (chart from, a great site):

Notice the timeline along the bottom of the chart, as this is a 200 year phenomenon, with the acceleration in the wildness of the swings since we gave a monopoly contract to a private bank to print money in this country (i.e. The "fed," which of course is not federal or constitutional). This chart is missing the most recent data but conveys the message of what you need to know clearly. As a society, we alter between favoring "paper" assets (i.e. Dow Jones as a proxy) and "tangible" assets (i.e. Gold as a proxy). These swings in sentiment and confidence are reflected in the ratio and reflect either confidence in the financial system versus a lack of trust in it. Gold is nothing short of a vote of "no confidence" in Wall Street's financial offerings.

As a basic fundamental investing fact, at major bottoms and tops in this ratio, if all you did was switch to stocks at the bottoms of this chart and switch to Gold at the tops, you would do better than at least 90% of investors over the long run. Other financial and hard asset proxies could create a similar-looking ratio chart, but these two have long and reliable histories with much historical data widely available for those who care to look.

Notice that when a swing in one direction starts, it doesn't stop until it gets to an extreme at the opposite end (though not without wild twists and turns along the way to keep investors alternating between fear and greed). The implication of this chart is clear: at some time in the next decade, the price of one ounce of Gold will be equal (or nearly equal) to the price of the entire Dow Jones Industrial index. As of today, Gold is in the neighborhood of $800-850/ounce and the Dow Jones is in the 10000-10500 range. Clearly, this current "cycle" has a long way to go.

In other words, you are making the wrong decision if you are invested in the Dow Jones (or S&P 500, etc.) for at least the next 2-3 years. This assumes you are not day-trading, playing weekly swings, or shorting the market. The easiest thing to do for a passive and/or novice investor would be to sell all stocks (including foreign stocks, which will tank with us) and buy Gold and possibly Gold mining stocks.

Do you doubt that this cycle can repeat? It has happened with a deflationary decade (i.e. the 1930s) and with an inflationary decade (i.e. the 1970s). We are in the middle of a global crisis in confidence that makes all financial firms suspect and people are wondering whether or not their bank will exist next week. Forget the so called "bail out" package (and the next one that will be proposed) - the government can't stop this train wreck from happening because they helped cause it in the first place, but that story is for another day.

I do not know some of the most important information, which includes the million dollar question everyone who is interested should be wondering: at what price point will these two intersect and when will it happen? It could be at a Dow Jones of 1000 or 20,000 and don't think it is impossible for either of these two scenarios to occur. Personally, I think it will be closer to 1,000 but a currency crisis could change some of the dynamics. The bottom line for investors: we are in a bear market for stocks (stay AWAY! SELL!) and a bull market for Gold (buy, buy, BUY!), and neither is over by a long shot.

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