Sunday, 6 January 2008

DJIA-to-Gold Ratio: Is Gold the King?

Chart junkies love plotting and analyzing relationships between different variables over time. Since I keep track of some of the market indicators, I do plotting too sometimes and think the following diagram looks pretty interesting in the light of recent market trends:

The diagram above depicts the historic time series of the year-closing Dow-to-Gold (DG) ratio, which is calculated as the year-closing Dow Jones Industrial Average Index value divided by the year-closing gold price (USD per ounce).

What can one say by looking at this picture? First, we can clearly see the long-term uptrend in increasing tops of this ratio, as well as the long-term horizontal support in the range of 1.5-3. Second, if we look at where we are right now (just past the 2007 value of the DG ratio, which is equal to 15.9), one obvious conclusion is that the ratio is well on its way down to the long-term support line. As the U.S. economy seems to be entering the recessionary stage and as the price of gold soars towards record highs, it is very likely that the DG ratio will respect its historic trend and will continue falling over the next several years.

On the diagram, I plotted the estimated trend in the DG ratio towards 2012. The actual journey towards the long-term support may take less or more than five years and it may be interrupted by short-term stops or even small upward breakouts. Are we entering the Big Recession similar to the ones the U.S. economy experienced in 1973-1975 and 1989-1992? Will the DJIA index and other stock market indexes fall by 20-30%? Maybe or maybe not, because there are so many factors involved.

One thing that I am convinced about is that the real value of the U.S. dollar will continue to fall. What else should you expect when the U.S. money supply currently grows at the annual accelerating rate of 13-15%? The mind-blowing widespread use of consumer and commercial credit, highly leveraged speculation in financial and real estate markets, excessive use of derivative instruments without due understanding of relevant risks, lower international demand for the U.S. currency from foreign institutional players and individuals, largely irresponsible monetary policy, huge public spending on unproductive military expenditures, flawed fiscal policy, growing unpopularity of Americans and of the aggressive American diplomacy around the world, etc, etc... The list of negative factors can go on. With all my due respect to the U.S. currency, it is eventually possible to end up being in a situation like this:

So what is the conclusion from the presented diagram? Looks like it is Gold, not stocks or Cash (i.e., US dollars), which is going to be the King over the next several years. Let's buckle up and enjoy the wild ride.

This post has been published in
Carnival of Personal Finance #134.

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