The Dow/gold ratio is simply the Dow Jones Industrial Average divided by the price of one ounce of gold. (Good explanation here.) It appears that even many investors aren't familiar with it, though it's of course well known among gold bugs. As you can see, the ratio hit 1 in 1980, and in my view could well do so again, as we're in an economic crisis the likes of which haven't been seen since the Great Depression. In 2000, at the height of the tech bubble, the ratio was at an all-time high and has been declining ever since. Notice also that the swings have become more erratic since the creation of the Federal Reserve in 1913.
The ratio suggests an easy way to invest, switching between stocks and gold when the ratio is at extremes. Anyone who did so would have outperformed probably everyone. The ratio currently stands at just under 10. At a Dow of 4000 and gold at $4000, not an impossible scenario in my view, we'd be back to 1.
You have to toss out all the data from before 1913. Something changed there. We went off the gold standard, created the FED, etc. So, that would be a regime change. The value of gold was being supported by governments. Data from that pre-1913 period is not comparable since a completely new way of operating has been pursued since then. (Of course, if you think we will go back to that gold standard then you should just use that data and ignore the stuff after 1913!)
ReplyDeleteOk, so you've thrown out the old data. You'd have to re-draw your mean since 1913. Eyeballing it appears that the line would be flatter and variance would be much, much higher (confidence interval wider).
The new correlations & data might even prove to be insignificant. It would be especially hard to trade this by "switching at extremes" with that much variability. How do I know what an extremem is? You can make zillions switching at extremes with any two non-correlated asset classes. Modern portfolio theory works incredibly well if you switch between long bonds and stocks... "at extremes" but who does that well!?!
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The academically proper, intellectually honest way to analyze this would be to put the two investments in terms of period returns, and then analyze the correlation of returns. Dow pays dividends, gold has storage costs, etc. All that needs to be included.
Good luck!
Thanks for the link to the description. A very interesting way to invest. I of course had heard about it but it amazing that so few investors haven't. I guess it's because so many on Wall Street discount gold as a worth investment. Perhaps because it lacks the "risk" the rest of the market has.
ReplyDeleteThe DJIA (the original, 12-stock version of it, at least) only goes back to 1896. This chart goes back to 1800.
ReplyDeleteAlso, the gold standard didn't end in 1913. It ended in the 1970s (though FDR had briefly suspended it and also devalued the dollar in terms of gold in the 1930s, in the face of a deflationary depression). That's another problem with this chart.
ReplyDeleteI'm not saying your overall thesis here is wrong or right, but this chart is pretty sloppy evidence for it. I'd figure you'd want to be a little more rigorous about this.
What are you saying Dave?!? This chart is from a goldbug. They would never twist or deceive. It's not in their nature. The Fed does that.
ReplyDeleteTo Anonymous, whom I believe must be Alan Greenspan in disguise, of the following asset classes, which look cheap to you?
ReplyDeleteStocks
Government bonds
Corporate bonds
Residential real estate
Commercial " "
Private equity
Precious metals
With all your talk, I'm guessing that your fully invested in equities, right?
Actually, Greenspan went through a goldbug phase, too, so did Buffett and a lot of other smart people.
ReplyDeleteDamn, I wish I was fully invested in equities! What a run! Truth is, I have a measured amount of equity exposure that I'll never sell. I own some ibonds and some tips... and a lot of cash, too much cash. I own some warrants in a canadian gold miner and I own some shares of sprott. I have a shotgun and some physical silver (that I eat with). Just like every other saver on the planet... I fear inflation.
Normally, I spend a lot of time looking for bargains and tiny off the radar value investments. For the last 6 months I've been working on my house and not paying too much attention. I recommend Value Investors Club, of which I'm a member.
To answer your question about cheap asset classes... if I had to pick it'd be XLP. I can explain that better another time. I'm late for something.
I enjoy your blog. Sorry if I'm ever rude.
"The last duty of a central banker is to tell the public the truth."
ReplyDelete-- former Federal Reserve Vice Chairman, Alan Blinder.
"Normally, I spend a lot of time looking for bargains and tiny off the radar value investments."
ReplyDeleteI love those sorts of investments, and own three from the VIC (though I'm only really bullish on one of them right now). What do you like now?
Here are three tiny, off the radar stocks I like, two of which have been on runs recently: DSNY.OB (that's the VIC one), USEG (that's one I used as an application for the VIC last year that got rejected -- the VIC's loss, at this point), and AYSI.OB. You can find plenty of my scribbles on those three companies on my blog, including some notes on my occasional conversations with the respective companies' CEOs and CFOs.
"The ratio suggests an easy way to invest, switching between stocks and gold when the ratio is at extremes. Anyone who did so would have outperformed probably everyone."
ReplyDeleteAs with any trading strategy, identifying the "extremes" is the hard part.
We're going even lower than a 1-1 Dow/Gold ratio.
ReplyDeleteThis chart has a "megaphone top" pattern.
http://www.trending123.com/patterns/reverse_symmetrical_triangle.html
"A Megaphone Top is formed because the stock makes a series of higher highs and lower lows. The Megaphone Top usually consists of three ascending peaks and two descending troughs. The signal that the pattern is complete occurs when prices fall below the lower low."
The ratio suggests an easy way to invest, switching between stocks and gold when the ratio is at extremes.
ReplyDeleteActually, it suggests an easy way to lose your shirt.
What if you had sold the top in 1960 (before anyone had worked out that a "Megaphone Top" was brewing)? You'd have been waiting until 1980 to even break even.
What if you had bought the bottom in the late 70s? You'd have been waiting until the early 90s to break even.
To the VIC members here, just curious, does the word "Praetorian" mean anything to any of you?