Dow/Gold Ratio Headed Lower

 |  Includes: CEF, GLD, GTU
by: Kevin Parker

For years, I have been monitoring the ratio between the Dow Jones and the price of gold. While not a comprehensive gauge of the stock market, I do like to keep an eye on it in order to get an alternative view of the value of the stock market.

As we all know, the markets have essentially doubled since their lows in March of 2009. We all love rising stock markets, but a problem is introduced when you mention that the dollar has weakened in the same time frame. If stocks are going up, but the dollar is going down, is that a good thing?

The Dow/gold ratio helps us to anchor stock prices to an alternative form of value or money, namely gold. Gold cannot be printed by a central bank and has been viewed as a form of money long before the US dollar came into being. As such, it makes sense to compare nominal stock market values to values against something like gold.

Again, I don't recommend using the Dow/gold ratio as your primary tool of valuing the markets, but I do recommend using it as a part of your set of tools used to value the markets.

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(Click to enlarge)

As you can see the ratio is hitting new lows over the last couple years (still not as low as the early 2009 lows).

The long-term trend over the last decade has been that of a decreasing Dow/gold ratio when it peaked at the height of the dot-com bubble. You could say that we've been in a constant bear market since then if you're pricing stocks in gold. I expect this to continue further and maybe even approach a ratio of 2 or 1.

Major "bottoms" in history have occurred when the Dow/gold ratio hit or approached 1. I don't know for sure if this will happen, but I can tell you that if it does happen that it will be a great time to sell gold and buy stocks.

Will you be fine if you just held cash and then bought stocks at this ratio? Maybe, maybe not. If the Dow and price of gold were both at 5,000, then your cash might still buy a relatively good amount of stocks. If the Dow and price of gold are at 20,000 then your cash is definitely worth much less. See how this works? The ratio doesn't tell you what your cash buys because it is only factoring in the Dow vs the price of gold.

Now, I'll briefly mention that gold is a very good holding at the moment even in the face of the end of QE2. While I sold my silver positions when silver was in the high 40's, I put all that money into gold positions. Why? First, because gold was drastically outperforming silver and gold is more of a monetary metal than silver whcih is my focus.

Central banks hold gold and not silver. While rich guys bash gold in the public, they also buy it in private. Gold is the ultimate hedge against a deteriorating global financial system which we absolutely are seeing. How does a US dollar based global financial system get replaced? Little by little, and that is exactly what is happening. Go with the central banks of the world and own gold.

I'm not an expert on the SPDR Gold Trust ETF (NYSEARCA:GLD), but I've read too much about the skepticism of the ETF's actual gold holdings. As such, I've chosen to put my money into Central GoldTrust (NYSEMKT:GTU) which has legitimate independent auditing of its holdings. GTU is managed by the same team as Central Fund of Canada (NYSEMKT:CEF) which splits its holdings between gold and silver.

Disclosure: I am long GTU, CEF.