Friday, December 26, 2008

Dow to gold ratio - how long will it take?

If a continuation of the current deflationary bust is the way we are going to get to a 1:1 ratio between the Dow Jones Industrial Average and the price of one ounce of gold, it won’t take very long if the last time it happened is a guide. The peak of the Dow:Gold ratio in early fall 1929 was slightly less than 19 when the Dow was at 386 and ratcheted down to a 2:1 Dow:Gold ratio nadir by 1933. The gold price didn’t change a bit during this period, as it was pegged to the dollar at fixed price of $20.67/ounce. The Dow, on the other hand, fell by 90% to reach 40 in the summer of 1932 – less than 3 years!

If you think a similar Dow:Gold ratio can’t happen again today, ask yourself why. Is it because we are smarter today than we were then? Gimme a break. Is it because we are more sophisticated today and have learned from our mistakes? The only thing we have learned is how to increase financial leverage to an even greater extent so that the subsequent bust promises to be even worse! Is it because you don’t want to believe it can happen? This is a plausible explanation for most, because who wants to believe everything we have been taught is wrong?

Buying and holding general stocks for the long haul was built into the psyche of the current generation of investors because it worked so well from 1982-2000. Everyone is now starting to realize that maybe it doesn’t work. We’ll have a nice stock bounce into the spring to keep a few holdouts in the bull camp, but then a tsunami of reality will destroy the portfolio of every Pollyanna praying for profits. Then you’ll really see the market crash as people stumble all over each other to get out of the market at any price.

For those who doubt this bear market can get any worse, do you honestly believe that our stock market can escape with a one year bear market when:

• The United States’ (and the world’s for that matter) banking system is insolvent
• Nearly half of the large Wall Street firms no longer exist due to recent bankruptcy
• A housing crash that is already giving the Great Depression a run for its money is just starting to pick up serious steam
• Our government has added nearly a trillion dollars of debt to its balance sheet in the last year despite already being bloated with debt
• Unemployment is still surging in earnest at the exact same time consumer debt loads are higher (in both relative and nominal terms) than ever
• Commercial real estate has begun to implode at an astonishing rate and retailers are about to start going out of business in droves
• The big 3 auto firms need government handouts just to stay alive until spring

This is not a gloom and doom scenario for the prepared, it is an opportunity. What a relief that all you have to do is buy some pieces of metal and hold onto them to come out of this mess with your retirement money unscathed! What could be easier and less scary? No need to worry about fraud, recession, counterparty risk, currency crisis, industry nationalization or corporate bankruptcy! Gold is the easy, low risk way to achieve a reasonable rate of return and maintain your savings. Buy physical gold and forget P/E ratios, growth estimates, and hot stock tips and just relax!

I have had people ask me how to reconcile this advice with the fact that their 401k/403b only offers limited investment choices. Let me give you a scenario to clarify your thinking: let’s say you know your stock investments in the 401k/403b are going to lose at least 40% more of their value over the next few years. OK, well that scenario is reality. What should you do? If your retirement option is to get a 30% tax break up front so that you can lose 40% of your money, I would say you should avoid that option!

If you have the energy, you can petition your employer to expand choice or allow you to set up a self-directed account. You can also sell everything in the account this March or April after the current bear market rally is near its end and move to cash. In the mean time, don’t throw more good money after bad just because you pray and hope things will get better! This means you have to seriously consider whether or not you should continue to put your hard-earned money into a retirement plan with shitty investment options.

General stocks will lose money/value relative to gold over the next few years and should be avoided except by short-term traders. For the more adventurous, a higher risk, higher reward play over the next few years would be to buy a basket of blue chip gold mining stocks. Government bonds have made the bulk of their bull move already and offer low returns and high risk and are no longer a good way to protect savings – cash under the mattress at this point has a similar return with less risk (and I would recommend gold as more reliable cash option).

Bottom line: I think the Dow to gold ratio reaches one in less than 5 years, which means stocks have a long way to tumble in the near future and gold will rise up to meet them. I also wouldn't be surprised if the ratio falls below 1 and one ounce of gold becomes worth more than the once mighty Dow Jones.

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