Trade Stocks or Invest in Gold: Using the Dow:Gold Ratio

I tend to think of investing and trading in stocks as a somewhat aggressive, more offensive type of investment strategy.  Conversely, investing in gold is a more defensive posture where the goal is to preserve wealth and maintain purchasing power in the midst of an adverse economic climate.  Certainly, in today’s economic uncertainty, one should be investing in gold; although I feel you should have exposure to both types of investments.  But, how do you know when to start looking more to stocks and shifting additional money into them?  If there was only one tool to help you decide, the Dow:Gold Ratio would be the one.

Before I get into the Dow:Gold Ratio, I would like to discuss secular markets.  Secular markets are not in contrast to spiritual markets.  A secular market is defined by Investopedia.com as “a market driven by forces that could be in place for many years, causing the price of a particular asset class to rise or fall over a long period of time.”  This is usually caused by some macroeconomic shift or other external force that runs over many, many years.  The secular bull market in the U.S. stock market from 1980-2000 was propelled in part by the decrease in the high rates of inflation which made stocks a more attractive investment, the hope for America’s future with the policies of the Reagan administration, and the demographic phenomenon known as the “baby boomers” who were entering their peak earning and investment years at the same time.

Gold, on the other hand, peaked in 1980 and then began a two decade decline in its own secular bear market.  The same trends which caused equities to rise led to investors preferring paper investments over the safety of gold.  With the election of Ronald Reagan, the Iran hostage crisis was resolved and a new foreign policy was initiated which ultimately led to less political uncertainty and the end of the Cold War.  Less geopolitical turmoil decreased the fear that leads to gold investment.  In 1999 and 2000, the bursting of the internet bubble, the World Trade Center Attacks, the massive increase in the government deficit, and the current financial crisis has led to a decade long secular bull market in gold.

The graphical representation of these macroeconomic and political trends yields the Dow:Gold Ratio. I tend to think of it as a hope:fear ratio. When hope about the future predominates, investors are willing to assume more risk and are looking to increase their fortune. The result is that there is a greater demand for stocks leading to an increase in price. This causes the Dow:Gold Ratio to increase. When circumstances change and fear begins to appear, this manifests itself as an increasing interest in real assets, especially gold. As investors begin to flee paper assets, the negative sentiment can feed on itself leading to progressively lower prices over years and years.

Looking at the chart of the Dow:Gold Ratio below, one should observe several points:

• Over the past 80 years, there have been 3 major stock market peaks as represented by the Dow occurring in 1929, 1966, and 2000.
• The time between 1929 and 1966 is 37 years.
• The time between 1966 and 2000 is 34 years.
• The ratio at the peak has been getting progressively higher.
• Both troughs have been below 5 and have remained there for several years.

In March of 2009, the Dow Jones Industrial Average hit its lowest level in years at 6440.  On that same day, gold traded around $920 per ounce yielding a Dow:Gold ratio of 7.  Since then, the stock market has had a fairly significant rally so that as of this writing in July 2009, the ratio is 9.  Practically speaking, we are 9 years into a secular bear market for stocks and a secular bull market for gold.  I suspect that we have several more years where the gold price will rise relative to stocks, and the Dow:Gold Ratio will remain in or near single digits.  We may not see it below 5, but it may drop again from today’s value.

The time to start thinking about getting out of gold is when the ratio begins to rise, and all your neighbors are starting to talk about their gold investments.  That’s when the forces that drove the secular bull market in gold have reached the masses, when stocks have been left for dead, and macroeconomic and geopolitical uncertainty has reached a peak.  Everyone will be fearful and will have rushed into gold as a safe haven.  Then the astute investor can begin to start selling some gold investments and cautiously raise cash for investing in the stock market.  By following the Dow:Gold Ratio, you can, at a single glance assess the relative fear and hope in the stock market and make rational decisions on where to invest.