Dow/Gold Ratio: Too Early To Buy Equities

by: Asa Harrington

Of late, a plethora of articles have been written here on Seeking Alpha and in the general financial news, purporting that we are starting the new bull market. Don't forget Eastwood's heart riveting half time commercial in this year's Super Bowl claiming it's half time in America and that our second half is about to begin. The end of the first half wasn't pretty and the last couple of years have borne witness to unbelievable bear markets, including a slide of more than 6600 points on the DJIA in the 16 months from October of 2007 to March of 2009.

But the 2012 surge (the best YTD performance since 1979) has seemingly woken up the Wall St. bull despite terrible news from over the pond in Greece and Europe. A recent Time Magazine's bullish cover and article on Warren Buffett's optimistic view on United States Stocks sums up the new feeling aptly.

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It is very understandable why investors believe America's engines are ready to roar again because economic indicators in America are turning up even though bad news barrages us from all sides: China's growth machine slowing, Europe's PIIGS debt crisis and Greece seemingly ready to implode. Hasn't America had our recession and stock market crash? Hasn't unemployment surged and been curbed? Japan might be the land of the rising sun, but America's roads are paved with gold and the rising hope of American investors.

But this is not the time of irrational exuberance says the Dow/gold ratio. The Dow/gold ratio measures the number of gold ounces it would take to buy a share of the Dow Jones Index. The graphical representation of the Dow Jones Index below is log scale so it is easier to identify percentage increases and decreases. (All graphs are my own, unless otherwise attributed, and monthly data was compiled from FRED St. Louis Reserve, Wren Investment Advisors, and KITCO.)

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As one can see from these two graphs, the DJIA peaks and bottoms correlate highly with the Dow/gold ratio peaks and bottoms respectively. When first glancing at the Dow/gold ratio graph above, it would appear the "real" value of the Dow Jones Index has gotten hammered in the last decade and that this might easily be signaling a bottom and that stock market woes are a thing of the past if the past trend is indicative. However, I encourage all bulls to look at the log scale Dow/gold ratio graph below because I believe it tells a more complete story.

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This log scale graph tells a similar story, but it also shows that the ratio might indeed have further to fall before a bottom is realized. The January Dow/gold ratio currently stands at 7.2, a far cry from the other major bottoms of 2.22 and 1.32. If history has anything to say, the Dow/gold ratio has not fully bottomed out but could be tracing a wave pattern similar to the false bottom before the Jan 1980 bottom.

Some scenarios that are possible in order for the Dow/gold ratio to fall another 60% and be under 2.5 could be: the Dow collapses by 60% to end up around 4200 while the price of gold remains around $1750/ounce, a surge in gold's price by 290% to around $5000/ounce while the Dow stays in its current trading range, or a combination of the two. Given these scenarios I believe it is more likely that either gold's price will surge or a mixture of the two will occur.

Why is gold still underpriced?

While the DJIA has stayed relatively high, gold has soared during the last decade, which has contributed majorly to the Dow/gold ratio down trend since the peak in 1999. This characteristic is very similar to the decade leading up to the 1980 bottom when the price of gold then too soared relatively. Again, the graph below is log scale to accentuate percentage changes in gold's price for the periods mentioned.

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From this graph, we can verify that if that the Dow/gold ratio does indeed have further to fall maybe one cause will be gold continuing to rise because it has not traced out a similar boom to that of the decade leading up to January 1980.

To add on to the argument that gold may not have topped, let's compare gold as a percentage of world assets in the bubble of 1980 and now.

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Borrowed From U.S. Global Investors

Compared to the peak of the 1980 bubble, in 2010, gold only represented a third as much of Global Financial Assets. While the price of gold has increased 70% since 2010, the price has further to go to reach 1980 levels of valuation. This suggests to me that this time around the gold bubble has more growth ahead before a top in gold and a bottom in the Dow/gold Ratio and major bottom in the DJIA.

On a longer time scale, increases in the monetary base seems to indicate gold is still underpriced.

Monetary Base United States (Highly Liquid Base Money or M0):

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Borrowed from Shadowstats.com

The monetary base has increased 38,600% since 1918 while the price of gold in dollars has only increased 8,440%. If indeed gold is a fair retainer of "real" value then it would appear gold may be underpriced.

Regardless of whether a continued surge in the price of gold is coming, I believe the Dow Jones Index has not bottomed. When viewed from a historical perspective we have further to go down in the Dow/gold ratio before the next big bull market begins. I am looking forward to this turning point, as it will likely be the best buying opportunity for another 20-40 years for equities. It is midnight in America and too early for the Dow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.