Time For Gold Bugs To Pay Attention To The Dow/Gold Ratio

Includes: EMX, FNV, GG, GLD, PHYS
by: Simit Patel

For my fellow gold bugs - meaning those who are already convinced that the price of gold will continue to head higher until the sovereign debt is crisis is resolved, most likely through massive debt monetization (i.e. printing money to pay off debts) and corresponding currency devaluation -- the big question is not if gold will go to new all-time highs, but rather how higher gold will go. Personally, I like the formulas advanced by James Turk and Jim Sinclair, both of whom use mathematical formulas to determine what the price of gold needs to be so that debt can be cancelled by payments in gold. Both these formulas forecast gold in excess of $11,000.

A more modest view can be obtained via the highly cited Dow/gold ratio, which has a historical tendency to revert to 2:1. With the Dow at around 13,200 and gold at approximately $1,630, the Dow/gold ratio is currently hovering at around 8. What if this is the top in the Dow? Certainly price has been consolidating in a tight range after a sharp move up. This type of price action often indicates a trend at exhaustion, where buyers are no longer stepping in and bears are beginning to quietly accumulate short positions. The chart below illustrates.

(Click to enlarge)

What if this is the top in the Dow, and that it does not churn much higher but rather remains fairly range-bound? Personally, I do believe we are headed much higher; as I noted previously, I think so long as debt levels are growing and money supply is expanding, the trend will be for higher stock prices as capital running from bonds as well as the new money banks create will conspire to send stocks and precious metals higher.

But an alternate scenario that should at least be considered is as follows:

  • Additional capital from the Fed doesn't do much besides prevent a big sell-off
  • The bond market remains strong enough
  • A new international monetary agreement is established in which some of the national debt of the respective nations of the world is formally cancelled

Suppose in this world the gold price is much higher - suppose it's at $6,250. Debt has been partially cancelled, the bond market is holding up, and equities have been range-bound for years. Then would you be interested in buying the Dow?

Further consider that during the gold bull market of the 70s, the price of gold went up about 24X - from $35 to $850. If we use $250 in 2001 as the starting point of the current bull market, a 24-fold move would give us a gold price of $6,000.

That is at least one scenario in which I can begin to seriously consider selling gold. It requires a price that is at least three times away. Moreover, I think gold stocks will have gone through significant appreciation before a top in the spot gold price is reached. As a general rule of thumb, if I'm confident the nearest top is more than two times away, I find it to be worthwhile to focus on accumulation.

In terms of what I've recently accumulated during this sell-off, I've picked up a few more gold coins. I don't use ETFs like (NYSEARCA:GLD) and (NYSEARCA:PHYS), preferring instead to take delivery of coins and bullion as well as utilizing vault storage services. And regarding stocks, I've bought Eurasian Minerals (EMXX), Franco Nevada (NYSE:FNV) and Goldcorp (NYSE:GG) within the past week. These are all assets I expect to hold for some time, possibly until gold reaches $6,000 - an event I think will happen within 10 years, and in fact probably within five, as I do not think the sovereign default crisis can be kicked down the road much longer.

Disclosure: I am long GG, FNV, EMXX.