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Dow To Gold Ratio

Dow to Gold Ratio

Pause Ted Mayer

Dow Jones Industrial Average to Gold Ratio is one of the most famous indices often used by bullion investors. It demonstrates how many ounces of gold are needed in order to buy one Dow Jones, which is based on 30 biggest stock exchange companies. Extreme points of the index depict long-term macroeconomic conditions in the well-known crises situations. The following graph presents Dow Jones to Gold Ratio with three extreme lows:

Graph generated by:

The graph presents the actual ratio i.e. which includes the times after DJIA was created (there are also other demonstrations, which could include a surrogate index in order to illustrate a hypothetical relationship for the 19th century). Technical approach to this graph could reveal some resemblance between critical times and gold price of DJIA. The examples are in cases of the Great Depression, the Great Inflation of the 1970s and the Great Recession after the recent financial meltdown.

Despite similarities of movements in the graph there is no inherent tendency between the index and the long waves (of booms and busts). Especially when we realize that all three cases were happening in radically different institutional setups.

Great Depression is a case of hyperdeflation. Money supply collapsed within few years, which unleashed deflationary forces. Those forces lead to financial deflation and major falls for the stocks. At the same time, with banks and companies tumbling down, base money, or "outside money", became the king. Outside money, as the name says, is money outside of the commercial banking system. During Great Depression it was gold. With stocks crashing and gold increasing in value, an increase in Dow to Gold Ratio should come as no surprise. Apart from that other substantial features were present: gold was money, or the dollar was "fixed" to gold".

An era of Great Inflation in the 1970s is quite another case, poles apart with the 1930s, not only because of different institutional conditions (floating currencies), but also because the seventies have much more to do with hyperinflation than hyperdeflation. Since the thirties much has changed in the monetary system, gold ceased to be real money, it became an investment vehicle. Its function as the final means of payment was lost. Now it became a real asset, an alternative to "paper" assets. This function demonstrated its full blown potential after inflationary seventies, when gold reached its peak.

Whether Great Recession is closer to hyperinflation or hyperdeflation is a mystery yet to be solved, since we observe the symptoms of both. On the one hand central banks are highly engaged in aggressive monetary stimulus and money supply expansion. On the other hand there is a form of credit deflation. In the meantime commentators and bloggers are engaged in the fights over who is right: deflationists or inflationists.

Macroeconomically and institutionally the 1930s significantly differ from the 1970s and from the 2000s. Even if to some extent data behave similarly, it does not mean that they actually have to behave alike. How does this translate into Dow to Gold predictions? Simply put: just because the ratio reached 1,6 in the Great Depression and 1 in the Great Inflation, it does not imply that in the Great Recession the ratio should go to 7, 10, 1, or any other possible number.

The ratio is solely what it is and nothing more: the mathematical relation between the price of gold expressed in dollars and Dow Jones dependent on stock performance. The first one depends on demand and supply of gold. The latter on supply and demand for stocks. Naturally there are some economic forces and variables (e.g. monetary policy) that could lead simultaneously to changes in both gold and stock markets; changes leading to an increase of Dow to Gold index. But there are no constants in economic actions. This concerns the level of a particular index, but even the direction of movement. There is no underlying economic law which states that in extreme slowdowns one ounce of gold should buy one Dow Jones.

Despite the dissimilarities there is a common, historical denominator for those three cases. In all of them gold was a safety-valve. Possibility to run away from both hyperdeflation and hyperinflation, which were preceded by artificial booms generated by the fiat monetary system. Yet the safety-valve has no specific level, no magical mark, or numerical indicator, which should direct investor's decisions.

Pause Ted Mayer

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