Mining The Dow-Gold Ratio For Clues
The big rally in gold over the past few market sessions has caught my eye. It has happened at a time of dollar stability, of increasingly deflationary news, including October’s negative month-on-month CPI reading from the US, and as other commodities have failed to gain traction. Thus, the near-20% move we have seen in bullion, from US$700/oz just a few weeks ago, made me sit up and take notice. It looks like a move to US$840/oz may be on the cards, and sooner rather than later. And with an asset like gold, a move much higher can never be ruled out. When names like Citigroup are on the edge, and uncertainty in fiscal and monetary policy reign supreme, skittish investors can be forgiven for picking up a little gold for risk aversion purposes.
Because gold is perceived to be the quintessential inflation hedge, you may be wondering: how does this square up with my deflationary world view? The short answer is that gold is also a form of deflationary protection over the long term. This is because although the US is in danger of hitting deflationary times, high levels of inflation down the road could result from the deteriorating US fiscal situation and the dramatic rise in Federal Reserve cash creation. This is a possibility at some point, but that point is not yet in sight. For now, I would instead point out that the deflation view is playing out nicely in the equity markets.
And in fact, it ties in with our short-term gold view. The ratio of the Dow Jones Industrial Average to gold is at a 14-year low of around 10.0. We believed nearly three years ago, at 20.7, that the ratio would shrink over the long term, implying upside for gold relative to US equities. Clearly, this has played out, and we see no reason why this ratio cannot fall further, as we remain bearish towards stocks.
Ratio of Dow Jones Industrial Average To Spot Gold
Thus far, the ratio has contracted from over 42 during the tech boom in 1999, marking a 76.4% decline. The two biggest previous collapses in the ratio occurred in the 1929-1933 Depression period, when it dropped 89.4% to 1.95, and in the 1965-1980 inflationary bust, when it dropped 96.1% to 1.33. Taking the ratio to 5.0, which would be higher than the previous bottoms, would take us to Dow 5,000, assuming a move higher in gold to US$1,000/oz. This is pretty bearish, even for us, but this ratio has been a fairly reliable indicator thus far, and should not be ignored lightly. At the very least, it could imply that gold has much more significant upside than we are currently anticipating.