Dow/Gold Ratio and the Dollar: What Does It Mean for Value Investors?

Over the past year or so, I have been paying a lot of attention to the relationship between The Dow Jones Industrial Average and the price of an ounce of gold – which is commonly expressed by the Dow-to-gold ratio. On the surface, the ratio seems simple enough; if the Dow is at 10,000 and gold is at $1000 an ounce, the Dow/gold ratio is 10. Likewise, if the Dow is at 2000, and gold is at $2000 an ounce, the Dow/gold ratio is 1. But if you think about it, the relationship contains more than the two obvious components -- the DJIA and gold; the equation also employs a component most people tend to overlook, which is the dollar. And once you consider the Dow/gold ratio from this perspective, the added dimension has all sorts of thought-provoking, and even frightening implications.

For an historical perspective, I've borrowed a chart of the Dow/gold ratio from a brilliant article by a talented analyst named Steve Saville, from December, 2008 (click to enlarge):

Before we delve further into the Dow/gold ratio -- and the somewhat concealed role the dollar plays in its formation -- I want to talk about the performance of the Dow, alone, over the last 80 years. Many analysts and economists have been comparing our current economic fiasco to the Great Depression, suggesting that this downturn may be as bad, or even worse than that period's. On that note, I want to point out that, in 1932, the DJIA bottomed after losing almost 90% of its value; as of the close of business on March 20, 2009, the Dow is down 49.5%.

If the stock market is heading for a bottom similar to the 1930s crash, we have a long way to go; the Dow's high, in October of 2007, was around 14,150. If it loses 90% of its value, it will stand at a value of 1415. A lot of people believe that is precisely where the DJIA is headed, and philosophically, I agree. But, as with everything else in this terrifying time, nothing is as simple as it looks, and searching for an absolute value of 1415 on the DJIA could be a costly mistake.

In recent months, I've pointed out some fairly startling differences between this economy and the Great Depression. For starters, in the 1930s, the U.S. was a creditor nation; it essentially borrowed its way out of the Depression, and while I believe that was a mistake -- only prolonging the pain -- it was, nonetheless, one (very costly) solution.

Unfortunately, the country's current status as the world's largest debtor nation precludes it from employing that strategy again – although Ben Bernanke, along with Barak Obama's economic toadies, would have all of us believe it can work. If you buy into that theory, however, I want to remind you that the government is printing money and easing credit at an unprecedented rate. Sure, the prices of most asset-classes are falling, but that's part of the solution, not part of the problem.

The U.S. government, however, wants you to believe that the only cure to this disease, brought on by decades of inflationary money-printing and easy credit – which inevitably led to malinvestment, unprecedented economic volatility, and ultimately, several horrific economic collapses – is yet again to expand the money supply and to further ease credit until the U.S. consumer resumes his relentless and irresponsible plight to spend, rather than to save. I'm at a loss as to how anyone of a sound and rational mind can honestly believe that the solution to this type of economic catastrophe is yet more borrowing and spending. It's like saying the cure for heroin addiction is an overdose. It's preposterous.

Granted, I am a dyed-in-the-wool Austrian economist, and our definition of inflation is always the printing of money coupled with the creation of easy credit. Some of you are, of course, aching to extinguish my fire with a hose-full of Keynesian dogma, and to that I say, do your worst. But remember this: Keynesian theory – which its own author repudiated – has been around less than a century, but empires have been crushing themselves under the weight of their own reckless piles of printed money for eons.

Bernanke claims he can tame rising prices when they return – and they will return, with a vengeance. But how on earth can he possibly believe he can control rising prices? How will he reel in the dollars he and his gaggle of sycophants are so capriciously printing? Will he sell Treasuries? To whom, and at what yields? Does he really think that he can simply offload trillions of dollars of debt to the world at constant low rates? If so, he's a fool; if he sells bonds, he's going to drive their prices down hard, and that can only mean increasing yields! How is that going to help "tame" rising prices?

Here are a few more differences between the 1930s and our current calamity: in the 1930s, the U.S. had a significant savings rate. Today that rate swings between negligible and negative. In the 1930s, the U.S. had a huge manufacturing base; it exported far more than it imported. Today, the U.S. is, for the most part, a service economy. Its automobile industry – once the world's paradigm – is now crumbling under the weight of debt, bureaucracy, and union demands. Everything from computers to apparel is made by foreigners. Until recently, the U.S. consumer bought those manufactured goods with the money he or she borrowed from houses and credit cards – creating an economic house of cards. The house, however, has now imploded; the U.S. consumer is tapped out and cannot drive nearly 70% of the economy as it once did. And, to continue the comparison, in the 1930s, the U.S. dollar was backed by gold, which is no longer the case.

That brings me to perhaps the most important disparity between the Depression and our current situation. In the 1930s, because of all the factors I just mentioned, the United States found itself in a state of sustained falling prices. The government couldn't print money at will – it had to adhere to the gold standard to which it was obligated. Yes, the Great Depression was horrific, but at least prices fell, and continued to fall. Today, the vast sums of money the government is printing, coupled with the unprecedented easy credit it has put in place, ensure that falling prices are only a temporary phenomenon; indeed, the government is trying to create inflation! And as bad as the Great Depression was, I don't think any of us can imagine how much worse it would have been if the country had had to face 25% unemployment and rising prices. It's almost unthinkable.

Almost.

In the early 1930s, after the stock market hit its nadir, it rebounded to the tune of 150% in about a year. That would suggest that a savvy investor who gets in at or near the bottom of this bear could stand to make a fortune on the rebound. Is the stock market going to lose 90% of its value? I believe it will lose that much, or maybe even more. Does that mean a DJIA of 1415? Probably not.

Let's talk about the Dow/gold ratio again. If you look at the chart above, you can see that a ratio around 1 or 2 normally signals a bottoming of the Dow, as well as a top for gold. I say "normally" in the context of the last 80 years, in which the U.S. government has manipulated the economy and its currency successfully, time after time. Unfortunately, because of all the factors I mentioned earlier in the article – the country's status as the world's largest debtor nation, its status as a service economy, its savings rate, et cetera – the government has finally painted itself into a proverbial corner from which there is no escape. Skyrocketing prices are inevitable, which means – if you let thousands of years of history be your guide – gold is going much higher.

In nominal dollars, I do not believe the DJIA is going to lose 90% of its value, but in real terms, I believe it will probably lose considerably more than that. If we differentiate this economy from the 1930s in terms of the direction of prices, and we agree that, unlike the 1930s, rising prices are inevitable, then the Dow/gold ratio could approach 1 (or even go lower) even if the DJIA maintains its current level, or goes higher! In fact, if Bernanke is unable to "tame" rising prices caused by his inflationary mischief, it's very likely gold could surpass its real-dollar peak over $2000 in the early 1980s by a tremendous margin.

So, in the 1930s, because prices fell sustainably and continuously, the DJIA did lose 90% of its value, in real dollar terms. But if inflation causes explosive price increases this time, it's likely that, in real terms, the Dow will lose 90% or more of its value without actually falling much beyond current levels. And remember – the CPI is not the true measure of price-increases. Keep your eye on gold, as well as on things like gasoline, eggs, milk, and other agricultural products; these are the true measures of costs in our economy, and when those prices begin to increase rapidly, you will know Bernanke has failed.

As far as returning to stocks, well, my theory goes something like this: we need a way to calculate the real-dollar loss of value in the DJIA, as it relates to impending inflation, as measured by gold, and what better way to do that than the Dow/gold ratio? As bearish as I am on the U.S. economy right now, I still believe U.S. companies will be among the most innovative in the world once this all shakes out. To illustrate my point, consider some of the great German companies that survived world wars and the destruction of the Weimar mark: BMW, Bayer, and Daimler are among many more that withstood incomprehensible political and economic changes.

I am a value investor, and I believe earnings have a long way to fall before we're finished with this debacle. Nonetheless, I'll be watching the Dow/gold ratio carefully. Once it approaches 1 – whether that means a DJIA of 7000 or 700 -- I'll be looking at stocks very carefully.

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.

Copyright 2009, Paco Ahlgren. All Rights Reserved.

Comments

[Zoltan L. K...:]

Currently gold offers double "protection": again the crisis, and again inflation. This is in fact a win-win situation, because you can hardly expect that the current economic cycle recovers without rising inflation.

Mar 23 03:54 AM

[EJW3:]

Good article. I always find the smartest people are those that can focus on the major issues and explain their relevance simply.

Mar 23 04:19 AM

[RJK1:]

I agree with the author but think that the US Government will attempt to forestall bankruptcy by ultimately requiring Americans to buy long term treasuries as a "base" for their IRA's or 401K accounts. It will be sold as a prudent investment requirement given the recent volitility of the stock market and as insurance against significant future losses in stocks etc, but in reality it will be necessary for the Government to have continued funding of it's ridiculous levels of debt once the Chinese and others turn away from treasuries themselves. Never underestimate the ability of the government to build new ponzi schemes! Heaven help us.

Mar 23 07:13 AM

[yellowhoard:]

Excellent article! This has been my conclusion for some time now. I am surprised however that you would include TBT in your portfolio right now. It seems clear that Bernanke will artificially hold down bond yields for as long as it takes to get inflation back in the system.

Mar 23 09:11 AM

[D. McHattie:]

Great insight, Paco. I, too, question Bernanke's confidence that he'll be able to contain rising prices.

I think we may well find out what an inflationary depression looks like up close.

Mar 23 09:25 AM

[Hot Richard:]

I was batting around this very question: "How do you calculate ROI when your currency is kaput?" Timely.

"...U.S. companies will be among the most innovative in the world..."

You are such an optimist! But, I don't see it. I believe higher taxes (return to 70%?) and increased regulations always stifle innovation, and the US is squaring up to bear hug both (not to mention "nationalization"). No way we'll compete with countries/regions that are not saddled with these two gremlins. Next up will be protectionism and we'll lose another generation of innovation and prosperity. Remember that I'm talking about macro trends, not individual anecdotes of innovation (like the Snuggie).

Mar 23 09:37 AM

[5142152-337:]

Good article...like others you have written! One question I would like to pose for your opinion: How do you see the POSSIBLE merging of Russia and China (and possibly Japan) to overtake the US and divert the USD as a reserve currency?

Mar 23 10:12 AM

[ussmls7:]

What would happen if one central bank broke ranks & used all of thier greenbacks to buy Gold from comex? It could happen,just look at Russia & think of how it would add to the gold reserves, and what would it do to the price of gold? Just a thought!

Mar 23 10:56 AM

[isaac the t...:]

Excellent article. Even if people don't believe that inflation will be severe (hyper), it nonetheless will be strong. Others can debate the severity, but we will have to wait and see. I'm looking at a mix of metals, ag commod, energy, and emerging markets as a base growth/inflation/shortage strategy.

Mar 23 11:23 AM

[@TexasER:]

Good discussion here! I agree completely with the theory Paco lays out. The main problem I see with this analysis is too much emphasis on economic theory, without looking at geopolitical realities.

All countries are facing this crisis, albeit from different perspectives. Our creditors will allow the US to "restructure" the debt because they need customers to survive. That customer is the western consumer. If they allow this restructuring, then the US debt levels become manageable.

Then China's reserves are worthless and the world economy can slowly recover over a decade or so.

What if they don't allow the restructuring? In practice, this means that China dumps treasuries. The dollar crashes and the world order is thrown into chaos. The threat of global war looms, and the USD finds nice support at a much lower level, backed by the strength of the US military.

Then China's reserves are worthless and the world economy can slowly recover over a decade or so.

Mar 23 11:50 AM

[john1940:]

The Dow/Gold analysis is interesting, but difficult to embrace for risking what's left of our assets to invest. One thing I would like to see someone analyze is demographics of our current situation in the US. Anyone 50 yrs and older has seen his future cut in half or worse. Their savings, home value, retirement and future has been destroyed. I find it hard to believe that anything Washington does now is going to turn this group into spenders again. They are going to change their lives to salvage all they can to protect their future and they will do that by saving and not spending. I think Washington's efforts will fail to fix the economy or improve it in the future. It's all predicated on borrowing more and letting the government spend it. I don't know how this movie ends, but I don't like the story line. It can get worse.

Mar 23 01:26 PM

[Hot Richard:]

I think maaaaaaaybe Madeinwgermany is a bit of an extremist. (Whispering) The swastika gives it away!

@TexasER, what happens when the Chinese understand they have one billion potential consumers domestically? China is looking for a "graceful" exit from investing in the US. They got caught with too much US debt, they know it, and now they will poker-face their way into less US-exposure. I can move all my assets out of the US in a day, China cannot. Restructuring means little. How's the movement for a balanced US government budget going? Trick question...there isn't one! We'll have time to discuss this in more depth when the US gets in this mess again (and again).

The myth that China will always need the US as a consumer is being exposed. Unlike the US Congress/AIG relationship, China doesn't see the US as "too big to fail". That's the thing about developing countries, eventually they develop. You might want to glance over at how many Chinese are running around Africa these days. I smell Kung Pao cooking in the tajine!

Mar 23 01:40 PM

[Edward Ulys...:]

What's disgusting is that the same Major Holders are in EVERY corporate entity within the Dow Industrials, AND in the bullion banks. They can easily make the ratio whatever they want to suit THEIR purpose. Face it, until it is no longer profitable to lie and steal, it will be difficult for ordinary folks to hang onto the profits of their labor.

Mar 23 02:00 PM

[Gedankonomist:]

"Granted, I am a dyed-in-the-wool Austrian economist, and our definition of inflation is always the printing of money coupled with the creation of easy credit."

Exactly. Saying "inflation" is "rising prices" is about as silly as saying "cancer" is "when you have a tumor." In some cases that is true, but it doesn't say much.

Mar 23 02:28 PM

[nova:]

The same, full of self-confidence and superiority over the rest, people who have conducted a terrible social experiment in Russia called " building a Communist paradise", are now have started a new social experiment: "building a social justice paradise" using the Treasury's printing presses.

The Russian experiment killed over 35 millions people and enslaved other 200 millions and also led to the WWII and the "Cold War". One can only wonder: where are we heading now?

I do not thing we can escape civil unrests and wars.

Mar 24 12:08 AM

[User 357469:]

Where are we heading now?

I think many of us know the answer to that even though few of us dare speak it. The financial world as we know it is headed for a complete collapse. The reason is simple. Like communism, capitalism did not work because both systems failed to account for the greed of the rich which sadly enough is based on oppression of others. Free market systems do not work because those who are more intelligent than other always find new ways to get money from the less fortunate. What we need now is a new world order fueled not by profits, but by understanding, tolerance and compassion for others. Only then will America and the world see much of a bright future.

On Mar 24 12:08 AM nova wrote:

> The same, full of self-confidence and superiority over the rest,
> people who have conducted a terrible social experiment in Russia
> called " building a Communist paradise", are now have started a new
> social experiment: "building a social justice paradise" using the
> Treasury's printing presses.
>
> The Russian experiment killed over 35 millions people and enslaved
> other 200 millions and also led to the WWII and the "Cold War". One
> can only wonder: where are we heading now?
>
> I do not thing we can escape civil unrests and wars.

Mar 24 01:50 PM

[Hot Richard:]

"Like communism, capitalism did not work because both systems failed to account for the greed of the rich which sadly enough is based on oppression of others. "

I have to take exception to your statement User357469. The common element between communism and the USA is a state with unlimited power compared to the people. The USA should be the comparison, not capitalism as the USA is a mixed statist economy and only a vague shadow of capitalism. By the way, who the hell was rich and greedy in communism per your statement? The state!

For any failure of the USA, first look to taxation, currency control, and New Deal expansion of the government. Don't start with one of the only things (capitalism) that actually helped people.

Any solution you would propose that would centralize power, rather than decentralize to the people (such as in capitalism, free markets, and...hell...freedom) is doomed to produce oppression the likes of which you cannot imagine. That last part should be read like James Earl Jones for the full effect.

Anarchists will have a lot of fun poking the corpse of the USA to show that even a democracy with benevolent leadership is doomed to the inherrent corruption of state power.

Mar 25 10:39 AM

[Whippet:]

Thanks again, Paco. Just look at the news today- even the IMF is contemplating (read: being pressured to) print its own money, and China is making it more and more clear that they are looking for an exit from their dollar reserves and T-bills (in the form of a new international currency). When Tax Cheat Timmy starts chatting about the IMF "mobilizing" its gold reserves, this can only be a good thing for the price of gold. Whether that cryptic statement means for the IMF to sell off its sizeable gold stores or to print fiat against it, it's just one more horse in the hyperinflation derby.
Gold will continue to face resistance as CBs sell off at certain price points, but there will reach a point in the intermediate term where they can no longer do this. At that point, resistance at $1000 will pop and the sky's the limit.

Mar 25 03:13 PM

[granger:]

Great article. Thank you.

Mar 28 11:39 AM

[granger:]

Follow up thought.

Do you have any thoughts of info on a Russell or S&P 500 - Gold Ratio?

I was just wondering how it holds on a broader based basket. Any thoughts, links or research ideas would be appreciated.

Mar 29 08:22 AM

[DONE_SONZ:]

Gold’s Percentage Rise in the Last Bull Market. What if gold in this bull market repeats the percentage rise in the last bull market? In the 1970s gold rose from $35 to $850, a factor of 24.28. Our low in 2001 was $255.95. Multiply that by 24.28 and you get a gold price of $6,214 per ounce.

U.S. Gold Holdings to Money Supply: The M1 money supply consists of currency and checkable deposits. The U.S. government currently holds 286.9 million ounces of gold. If the government were to make each dollar redeemable by the amount of gold it possesses, we’d arrive at the following price for gold: $1.569 trillion ÷ 286.9 million oz. = $5,468.80 per ounce

Gold/Dow Ratio: The ratio was about “1” when gold peaked in 1980, meaning the Dow and gold were the same price. To restore that relationship at today’s stock prices
would mean when the Dow is at 6,626, gold should be at $6,626/oz. Of course, we think it likely that the Dow will get a lot lower before gold peaks. But even if it drops all the way to 4,000, that would imply a gold price of $4,000/oz
*Found in an article recently on Gold newswire website.

May 02 08:41 AM

[granger:]

I have a question, why not use the S&P 500? or some broader index?

Sep 03 12:40 PM