The Dow/Gold Ratio Will Decline Further
The Dow Jones Industrial Average (Dow)/gold ratio is important because it indicates the optimism for financial assets versus that of hard assets. A rising ratio demonstrates high confidence in the economy and falling inflation expectations while a declining ratio indicates low confidence in the economy and rising inflation expectations. Although the current Dow/gold ratio of 9.3x is significantly lower than the peak of 45x that was reached in 1999, it is still nearly 9x higher than the levels that were reached at the bottoms of the 1930s and 1970s bear markets. During 2009, a significant increase in the ratio from 7.0x to 10.1x occurred, which rivaled the largest counter-trend move seen during the 1929-1932 stock bear market when the ratio increased from below 10x to above 14x. Following that move in 1930 (as seen in Figure 3), the Dow/gold ratio resumed its contraction during the remainder of the Great Depression era. Similar to that era, stocks are currently in a bear market relative to gold. This suggests that the Dow/gold ratio will not bottom until it reaches levels closer to those of the prior bear market bottoms, at roughly 1 to 2 units of Dow per ounce of gold.
The Dow/gold ratio peaked in 1999 at nearly 45x and has been declining ever since (Figure 1). This peak coincided with optimism for financial assets and disinterest in commodities.
Figure 1. Dow/Gold Ratio
Source: Bloomberg, Yahoo Finance
Although the Dow/gold ratio has been declining for over ten years, counter-trend increases have occurred when the Dow has outperformed gold. The strongest increase lasted from March 2009 through August 2009 when the ratio increased 44% over that 5 month period (Figure 2). Since the peak of 10.1x reached in August, gold has again outperformed stocks, suggesting that the counter-trend is over.
Figure 2. 2009 Dow/Gold Ratio - 44% rise from March 2009 through August
Source: Yahoo Finance
Although stocks significantly outperformed gold since March 2009, Figure 1 shows that it was merely a correction in the overall trend. As previously mentioned, a similar counter-trend move in the Dow/gold ratio occurred following the stock market crash in 1929 when the Dow/gold ratio increased by 48% during the 5 month period from November 1929 through April 1930 (Figure 3).
Figure 3. 1929-1932 Dow/Gold Ratio - 48% rise from November 1929 through
Source: Yahoo Finance
Why The Dow/Gold Ratio is Headed Lower
The Federal Reserve's policies of holding interest rates at 0% and inflating the monetary base have set the stage for high inflation, which will lead to a decline in the ratio. However, if the Federal Reserve has not yet printed enough money to offset the deleveraging associated with the unwinding credit bubble, then the Federal Reserve will be forced to institute even more policies to create the illusion of economic growth. Therefore, the Dow/gold ratio will ultimately decline further because of inflation regardless of the rate of economic growth or contraction. Whether stocks fall as gold rises, gold soars as stocks stagnate, or both stocks and gold go up or down together, the ratio will inevitably bottom much closer to 1:1 just as it did in 1932 and 1980 (Figure 1). With the financial and fiscal imbalances of the US much greater today than they were in 1932 or 1980, and the US Dollar under attack as a reserve currency, a decline in the Dow/gold ratio to that level is logical.
Gold's Recent Correction
Gold's recent correction from $1,225 has led market commentators to conclude that that the economy is strong enough to allow the Federal Reserve to raise interest rates to control inflation. In fact, these commentators suggest that the economy will become so strong that the stock market will be able to move higher even in the face of rising interest rates. However, if the Federal Reserve were to increase interest rates enough so that inflation could be controlled, the impact on the US economy would be devastating. The impact of even small interest rate increases would be dramatically negative for the carry trade, the bond market, the default rates on US Government holdings of mortgages (Federal Reserve, FHA, Fannie Mae and Freddie Mac) and the FDIC's guarantee of bank deposits. If gold has peaked because the Federal Reserve will increase interest rates, the Dow will have to fall 90% in order for the Dow/gold ratio to reach 1:1.
The Dow/gold ratio contrasts economic growth and prosperity with inflation and an undermined currency. Despite some commentators opining that the US economy is recovering, the fixed income holdings of the US Government and its on and off-balance sheet liabilities (such as Social Security and Medicare) will prevent the Federal Reserve from tightening monetary policy enough to control inflation. As a result, inflation will outperform economic growth and lead to a decline in the Dow/gold ratio, providing significant upside for gold relative to stocks regardless of whether they meet at 5,000, 10,000 or 15,000.