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Thursday, January 14, 2010

The Dow / Gold Ratio

I have a series of posts going regarding important Gold ratios. This is the fourth installment.

1. Gold Miner Performance: A Look At Miner Cost Inputs vs. Gold Price - Dec 30, 2009
2. Gold Miner Performance Relative to Gold - Jan 11, 2010
3. The Gold / Silver Ratio - Jan 12, 2010
4. This post - the DGR
5. Other Gold Ratios - forthcoming. I have written several posts on these that I will update.

The Dow / Gold Ratio (DGR) is another key ratio that describes the market behavior in real terms. This ratio is not as much of a "perception" ratio the way the Gold/Silver Ratio or the HUI/Gold ratio is. Rather it is a "value" ratio.

I have written on the DGR many times in the past including fairly recently: The Long View - Dec 17, 2009, Thoughts on the Dow/Gold Ratio - Oct 19, 2009, The Gold Blog. Gold/Silver/GSMs - June 15, 2009. As such, I will be borrowing a bit from these posts.

First lets take a look at some charts of the DGR:

First, following the format of my last 2 posts, I should define how a ratio should be interpreted and what gold means in historical investing terms. If you read my last post (The Gold / Silver Ratio) please skip the italicized section:

This is the Dow / Gold Ratio. When a ratio is increasing, it means that the numerator is increasing faster than the denominator OR the numerator is not dropping as fast as the denominator. Outperformance means either moving up faster or not dropping as quickly.

But first, let me talk a little bit about what Gold is.

Gold is sound money. Now you may be a gold bear, and think it is a useless shiny piece of ... metal. But the odds of someone of that mindset actually making it far down this post is probably unlikely. However, my point is, there are *many* people who feel this way, even if you don't happen to agree with them. And so it is important to understand what many other investors think. My $0.02, and take away from that what you want.

Gold is sound money, which means it represents safety. It is a safe haven move in times of crisis to go to physical gold or to funds that have claims on physical gold (there is a *very important* distinction to be made here about gold / gold funds / types of gold funds. But I have made them many times before and this is beyond the scope of this post).

So how does Gold measure up against Equity valuations (in this case, as measured by the Dow) over the historical record?

To answer this question, we must first disabuse anybody of the incorrect assumption that gold is an "Inflation" hedge... period. I have said this many times in the past, that gold is not only a hedge against inflation, but is a hedge against financial shenanigans and economic instability (loss of confidence).

There is absolutely nothing in economics that has only one cause and one effect. There are primary causes and secondary causes (and always multiple ones), and the primary cause at one time might become a secondary cause at a later time!!

"Gold is only a hedge against inflation". First this is an incomplete statement because it does not distinguish between monetary inflation and price inflation (most people are not even aware of the difference). And gold is a hedge against inflation (first and foremost it is a hedge against monetary inflation and is one of the few asset classes to respond to it early and directly. Moreover, all monetary measures are *NOT* created equal and you must use the proper, and in fact clearer/simpler form of money measurement, to understand monetary inflation, which is the True Money Supply / TMS - see: Steve Saville: Thoughts on Monetary Inflation. M2 and M3 have *non-monetary* components and are invalid for understanding the true scope of monetary inflation/deflation) and it is also, perhaps more importantly, a hedge against financial instability / loss of confidence.

It the 1980s, we had massive inflation. However gold dropped. So there is a contradiction right there. Why? Because Volcker's policies returned confidence back to the financial markets. And the future outlook, even though it was inflationary at the time, was deemed to be bright enough that people poured back into equities and left the safety of gold. (An example of a primary cause and a secondary cause switching importance).

Next, one must be aware the moves from speculation/optimism and risk aversion/pessimism run in cycles and each phase of the cycle has its own "personality"

As an example lets look at the first cycle where the DGR first began to move away from its long term channel - 1920-1940.

During the 1920s, the market was recovering from some strong moves and subsequent panics in the 1900s/1910s. But in the mid 1910s-mid 1920s there was a recovery period from these crises, and the mood generally became optimistic in the mid-20s (the Roaring 20s). By the late 1920s all kinds of new financials instruments were introduced / invented and copious amounts of leverage allowed for huge speculation in equities. Rhetoric in 1929 has very positive including calls of "market invincibility". And when confidence faltered the unhealthy / non-productive activity in the market came crashing down. Eventually stocks sold down so far as if the economy would never recover. And from this pessimism the next bull market was born.

In this case this economic cycle which the DGR clearly shows, was not as exaggerated since US monetary policy was still based on the gold standard.

But eventually the "freedom" from being released from the "shackles of gold" allows for higher highs and lower lows.

The same cycle of a large bull market in equity performance being borne out of the previous bottom of pessimism can be seen from 1935-1980, and we are in the 3rd cycle now.

Stocks become a ridiculously good value in nominal and real (inflation adjusted) terms when pessimism is at its greatest. I discussed this very point in this post: Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?. Stocks, as speculative instruments become extremely overvalued at cycle peak and extremely undervalued at cycle bottoms.

The bull run out of a cycle bottom is accompanied by increasing fundamentals, positive economic activity, and real reasons for optimism. Then about halfway through the the upside half of the cycle, optimism turns into recklessness. New financial instruments are offered / invented (Savings and Loan Crisis, Swaps, Derivatives, etc.). Rhetoric of "market invincibility" becomes commonplace (sayings in 2000 were very similar to the sayings in 1929). And the inflated market comes crashing down at worst, or consolidates at best. The next half of the cycle is the story of the transition away from risk and into risk aversion. Protection of capital is sought in safe haven investments.

And whether you personally agree with it or not, gold is and historically has been viewed as a safe haven investment.

Which brings us to now

We are not at the bottom of the current Dow/Gold Cycle. In fact, we are nowhere near the bottom (in my opinion). I have made the case many times (Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?, The Long View, Sentiment: P/E, BPSPX, VIX and CPC) that we did not reach any meaningful bottom in terms of price or valuation in March 2009.

So if the Dow / Gold Ratio has further to fall, there are a few scenarios on how it could play out:

a) Both Gold and the Dow could rise from here. Gold would take of frenetically and the Dow would rise more slowly so that the DGR would fall.

b) Both Gold and the Dow could fall from here. The Dow would fall faster than Gold.

c) Gold will rise and the Dow would fall.

All scenarios are very possible and no one knows which one will happen. But I have made my case for c) many times, and that is the one that I think has the highest likelihood of occurring.

But before I describe this scenario in more detail

I want to say I am not a permabear. I don't like being bearish on the economy. I am actually a very happy and very optimistic guy. And I do *NOT* think this cycle will end with the destruction of the World / US Government / Society, etc. .

You can see that I point out on the 200 year chart that equities will represent a tremendous value, as an asset class, in real terms when the ratio bottoms. In real terms because the price of gold represents the true inflationary impact of the US monetary policy. But I also think we will get a bottom in the Dow in nominal terms as well somewhere around this timeframe.

And I do not refer to equities being an excellent value sarcastically. I am quite serious. I am not bearish on equities for the sake of being a bear, nor am I holding gold because I like shiny objects.

I want to maintain my purchasing power as we go through this next period of massive inflation while stocks continue to fall due to poor fundamentals. But eventually I want to trade my gold in for something useful and productive, because I believe the worlds economies will recover.

Here is a passage I have written many times regarding investment in Gold, and why I consider investing in Gold an optimistic endeavor.

In my investment account that I am in gold and oil. Why? Because I am bullish on the very long term prospects for the economy of the US and the world.

.... Now that might seem odd, because aren't all the people who invest in gold assuming the world will end? The answer is no, at least for this gold investor. I invest in gold not because the world might end, but I invest because I firmly believe it WILL NOT!!. If I was uber-bearish for the very long term, I would build a bunker underground, stocked with years of food and buy guns. Gold? For the end of the world? It makes no sense. Why would a useless shiny metal rock be something to collect if civilization ends?

It is the same thing with fiat currency (such as the US dollar). If you really thought the world would end, why collect little pieces of green paper with faces on it? How is that possibly useful? If there is no government to give you goods in exchange for it, then there are better items for a bunker mentality.

So I invest in gold because I am an optimist.

I am not bullish on the US government. I think they will inflate the dollar into worthlessness (or devalue it highly at least). But ultimately economies WILL recover, and I want to trade my gold in for something useful. Shares in a profitable alternative energy company, or a company the produces / distributes water from seawater to sustain drought countries, or any number of productive future endeavors.

Gold is simply a way to maintain purchasing power as the worlds economy goes through this large and needed contraction. So as an optimist, you should invest in gold :) Just my $0.02 (silver coins of course, not actual pennies ... :) )

But wait a minute binv, you said option c = gold up, stocks down. Yet you say the environment will be inflationary. What gives?

To be very clear, I think the environment will be stagflationary. Massive monetary inflation in a falling demand environment.

First we need to talk about the Dollar, as it is an important factor in this discussion. Is it the start of a major multi-year dollar rally (some think so), or is it a bounce that lasts a few months (I am in this camp).

I think the Dollar Carry trade is about to unwind a bit. And I think this bounce was more or less engineered. The QE fund pool is almost dried up, and the demand from foreign governments during the last bond auctions was severely anemic. So the Fed needs a good "deflation scare" to get a second round of Quantitative Easing authorized.

And the purpose of this next round of QE will be to keep the government running, not to prop up the stock market. Like you observe above, tax revenues are down, yet the national debt ceiling is being *raised*. Government is *growing* in the face of shrinking revenues. And the only way to accomplish this is through deficit spending. And if foreign governments won't buy our debt to allow our government to run, then we have to buy our own debt (via debt monetization courtesy of the Fed, of course). It is the only way to keep the government running, other than slashing services. And the chance of that happening in an election year? Approximately 0.0%.

This is why the outcome was never going to be deflationary. As long as there is Fed, debt monetization will always be the preferred expedient action.

But just because the outcome is inflationary, it does not mean that assets will rise. I hemorrhage a lot when I read economic commentary because nobody tries to understand the complexity of the macroeconomic situation. And since 2000, we have seen first hand how little the ramifications of monetary policy decisions are made not only by the public, but even by those who are making them. I still hear a lot of "dollar down = stocks up" or "inflation means stocks will rise".

Inflation "helps" (used *very* loosely) stocks rise ... until it doesn't. Stocks can fall in an inflationary environment, because the economic fundamentals are weak, and the inflation starts to exacerbate the weakness, not hide it. This happened in the 1970s. And it is called stagflation.

When stocks fall again due to poor fundamentals, people will say this is proof of deflation. I mean after all, if assets fall, it's deflationary right? Not if you want to understand cause and effect and not if you want to understand what the macroeconomic ramifications are. Mislabeling the next downturn as deflationary is exactly the misperception that the Fed wants so that it can be more aggressive with QE and similar policies (ramp up inflation while everybody is focused on "deflation" -- which is actually a deflation scare). Hell, they even said they were buying more mortgage back securities today! (monetizing debt is directly inflationary). It believes that it is helping to solve the problem, but in actuality it is reinforcing it.

Peter Schiff had a great bit on his video blog (which kdakota always does a great job of reposting) regarding the PPI interpretation and extrapolation. Check out this post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=312473 and watch from 3:05 to 5:15. It is easy to see how this argument has ramifications for lower stock prices within an inflationary environment. The comparison between now and the 1970s has a lot of compelling aspects: high inflationary environment, poor fundamentals, and falling asset prices. The only difference now is that the structural imbalances are a lot worse. Which means that the monetary inflation is going to reinforce the problems much more than they did in the 1970s.

A valid question would be "well once the Fed realizes (supposing they do) that it is a positive term in the feedback loop, not a negative one, won't they just stop inflating?".

The first answer is: no. And the first clue is the yield curve. Nobody but the Fed is buying our long term debt. The only reason why the government is running at the moment is because the Fed is funding the Treasury, it isn't getting money from foreign governments (well it is, but in much smaller proportion). And the National Debt ceiling is being *raised*. The Fed needs to inflate to get the government running.

The second answer is: it doesn't matter. Because once the inflation is detectable in general prices, the massive monetary inflation will have already done vast amounts of damage. And because of the inertia in the economy, we will be feeling the aftermath of that inflation for a very long time.

Things you own go down in value, the things you need to consume cost more. Sounds like stagflation to me.

The Dollar and equities are far more positively correlated than they are negatively correlated. And I lay out the case in my Dollar post ( Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog ) where the weak dollar eventually hurts the stock market. Since, like I am saying above, the outcome was always going to be massively inflationary ever since Quantitative Easing was announced, the long term direction of the stock market was sealed: USD-SPX-Correlation_since_1990.png

Which brings me to my final point regarding inflation and how it "helps" asset prices (or how it doesn't) and how Gold fits into this picture

Inflation (monetary inflation) is the selected course of action. Always has been, always will be when it comes to the Government, Fed and Treasury. Prices of many asset classes have fallen and will continue to fall, and this in and of itself is *NOT* deflationary. But the Fed (and analysts like Krugman) continue to perpetuate the myth that price deflation = deflation ... which is WRONG! These "deflationary" events are deflation scares in which the Fed is given free reign to drop rates to 0% and monetize debt like there is no tomorrow, due to popular (and intentional) misconception about deflation and thus public acceptance of these polices.

So, binv, asset prices are falling. Why do I care about the academic distinction between monetary inflation / deflation and price inflation / deflation?

Because monetary inflation or deflation beget vastly different long term consequences!

It is cause and effect. Monetary inflation not only enters into the economy unevenly but also changes the structure of the economy. Non-productive enterprises are propped up (especially government spending). But the biggest difference will be the price of real goods, such as commodities and especially gold, will reflect their real costs (inflation adjusted). 

Many take this argument to support the theory that inflation will help stocks, as a general asset class, to maintain their levels. The only thing inflation will do will be to help stock from falling as far as they otherwise would. Please read this post for my explanation as to why: binve's Long Term View

Even in an inflationary environment, there are several asset classes that will continue to fall due to poor fundamentals. This is a demand issue and is not necessarily deflationary.

But there is one asset class that will maintain purchasing power through this period of massive inflation: Gold.

Notice my wording. Maintain Purchasing Power. Gold is *NOT* going to the moon! Anybody who thinks that does not realize what gold is. If gold goes to the moon, it is because the dollar goes down the the Earth's core. It _maintains_ purchasing power.

Gold is about holding value. Gold does not pay dividends, gold does not multiply, gold does not make the world go round. Gold holds value. That’s it. So gold is not a way to get rich. Let’s be very clear about this point. Gold is a way to be NOT POOR. Like I said, it holds value.

So if it goes to $5000/oz, it means that the economic toilet paper we call the US Dollar has been ravaged / devalued by the polices of the US Government, the Treasury, and the Federal Reserve. And you can now buy that much less with the Dollar. 

The problem is debt.

And the Fed has made it very clear that monetizing as much debt as is necessary to keep the system going, at the direct expense to the Dollar, is not only a course of action that is open to them, but THE course of action that they are taking and will take. Anybody who does not understand and accept this is a bit naive (IMO). This plan will continue until there is no longer a Federal Reserve

The fact that the population is becoming wise to this is a natural and not at all unforeseeable consequence. Savings is increasing. And yes, for many people, that means into gold too.


The point of this post, just like the point of any of my posts, is *not* to try to convince you of anything. I am an analyst who is sharing observations. That's all. It is immaterial to me whether you agree or disagree with my observations or conclusions. But I do hope that my observations are useful in helping you to formulate your own opinion, even if your conclusion is completely opposite of mine.
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