Saturday, May 2, 2009

The DOW/Gold Ratio

Brewski's, friends and the hockey game, not many better ways to spend a Friday night. And speaking of hockey, the Detroit Red Wings are looking awfully strong to repeat as Stanley Cup Champions, aren't they?

Discussion turned to the economy and your faithful scribe was relentlessly needled about his bearish outlook. April has been a month to remember (the DOW was up 7.3% and the S&P posted its biggest monthly gains since March 2000) and stocks of note like Teck Cominco have gone from $3.45 on March 9th to close yesterday at $13.99.

But the Whisperer continues to piss on the wheels of the optomism bandwagon.

Let's face it, during the last two months has any aspect of the economy actually improved?

Yes, consumer confidence has gone up a bit (probably because the stock market has bounced a bit) but every other measure of the economy is weak. The fact of the matter is that the manufacturing sector is still contracting and just because it is not contracting at the same rate that it was, its hardly grounds to say we are in a turnaround.

Remember... one of the surest things in the investing world is a rally after a major downturn. Typically, prices recover 20-50% of the previous decline. Then, the market crashes again.

With that theme in mind, I bring you the above DOW vs. Gold chart (click on the image to enlarge) from Agora Financial of Maryland. Take a moment and look at it.

This chart represents the Dow-Gold ratio, which tells you the number of ounces of gold it would take to buy the Dow Jones industrial average.

Currently it would take 9 ounces of gold to buy the DOW, a 9:1 ratio.

By comparision, at the height of the tech bubble in 1999, it took 44 ounces of gold to buy the DOW, a 44:1 ratio.

The interesting thing is, after every big 'bubble', the DOW/Gold ratio has always corrected to just about 1:1. In 1980 for example, when the Dow sat around 800, gold was $800 an ounce. The ratio - 1:1.

We are currently on the backend of a downslide from the highest disparity in the history of the DOW. We have moved from a 44:1 ratio to a where we currently sit at 9:1.

Since that ratio has always corrected itself to that 1:1 or 2:1 ratio, we are - in all likelihood - in the process of seeing the ratio corrected once again.

IF the historic ratio does come back to this 1:1 or 2:1 ratio, one of several things has to happen. (a) the DOW is going to crash hard, (b) Gold is going to spike dramatically, or (c) a combination of (a) & (b).

Some analysts are speculating we are probably going to see the number 5,000... meaning the DOW is going to crash to 5000 (from the current 8212, almost half it's current value) and gold is going to rise to $5,000/ounce (a 1:1 ratio).

[Note: a drop like this in the DOW would be entirely consistent with what the DOW did after the 1929 crash. It has been 19 months since the market started to crash. It was exactly at this point in 1932 - 19 months after the crash of 1929 - that the DOW crashed after a similar rise to the one we are currently experiencing. The similarity is almost spooky.]

Even if the market doesn't crash (let's say DOW stays at 8,000) and the DOW vs. Gold ratio only drops to 2:1, that would put the price of gold at $4,000 an ounce to achieve that 2:1 ratio.

About the only thing that would punch gold up to the $4,000/oz level would be a precipitous drop in the value of the American dollar.

And if the value of gold does not rise, then the DOW would have to crash to about 2000 (and gold stays at $1,000). That would also produce a 2:1 ratio.

Perhaps the DOW vs Gold ratio will not even out for a few more years, there is no guarentee that now is the time for the 1:1 ratio.

But given the absolute lack of valid fundamentals in the economy, I simply can't see anything but a stock market that is in the midsts of a bear market rally trap. And I am personally inclined to believe we are going to be seeing a combination of the DOW crashing and gold rising.

If thats the case, there's a whole lotta economic hurt on the horizon.



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