Friday, February 20, 2009

Gold To Dow Jones Ratio

With investor interest in gold beginning to pick up more steam, those already holding gold are probably wondering when the best time to sell their gold will be. In other words, how will when know when we are nearing the peak of the bull market in precious metals? There is no way to know that in exact terms. But a good indicator is the gold to Down Jones Ratio, if we look at its cyclical nature.

The gold to Dow Jones ratio can tell you when to buy and sell gold.

Looking at the graph showing Dow to gold ratio over an 80 year period, we can see that the value of the Dow Jones Index (which represents US Bluechip companies) measured in gold follows a clear rising and falling pattern between undervalued and overvalued. The rises and peaks on the graph show that the value of the Dow is rising, meaning that it costs more ounces of gold to buy a unit of the Dow. The dips on the graph show that the value of gold is increasing, meaning that it costs fewer ounces of gold to buy a unit of the Dow.

According to Michael Maloney in "Guide to Investing in Gold and Silver", the Dow is fairly valued at 6 or 7 ounces of gold per unit. It starts to be considered undervalued when it drops below 4 ounces of gold, and it starts to be considered overvalued when it rises above 10 ounces of gold. But the Dow usually strays far into overvalued or undervalued territory before changing course and moving in the opposite direction. When it has overshot the "normal" range of value in one direction, it has the tendency to overshoot the normal range in the opposite direction as well.

In 1929, it cost 18 ounces of gold to buy the Dow (very overvalued), and when the cycle changed course the Dow's value swung all the down to 2 ounces of gold per unit. That means anybody who sold their shares of the Dow and bought gold in 1929 did very well, and a few years later could buy 9 times as much of the Dow as they originally owned. So we can see that the Dow overshot the normal range on the way up, and then overshot it on the way down.

The same thing happened in the next cycle when the Dow peaked in 1966, even more overvalued at 28 ounces of gold per share. Because the value of the Dow become overvalued by a larger degree this time, on the way down it also became undervalued by a larger degree, reaching as low as 1 ounce of gold per share in 1980.

Today we are following the same cyclical pattern, with the Dow having peaked in 1999 at a whopping 44 ounces (!) of gold per share, and we are currently in the middle of the move in the other direction as the Dow becomes less valuable in relation to gold. The ideal time to sell is right before the Dow hits the bottom and changes course in the opposite direction. If you had bought gold in 1999 you would be in an amazingly good position to profit from this cycle. We have missed the peak, but there are years left in this cycle and you can still multiply the value of the gold you buy. Today I checked the value of the Dow, which was listed as 7346.31 US dollars per share. When I checked the gold price, it was US$993.74 per ounce. Divide the price of the Dow by the price of gold, and the result is 7.3926. That means that it currently takes 7.3926 ounces of gold to buy one share of the Dow.

How far will the Dow/Gold ratio drop? We don't know exactly, but conservative estimates suggest that 2 ounces of gold per share is very likely. But judging by how far the Dow overshot the normal range of value in 1999, it could very likely overshoot the normal range by a huge degree on the way down as well. Some say that it could likely drop to 0.5 ounces of gold per share of the Down. That means that if you buy now, you will increase your invested wealth by 1400%. In a very conservative estimate, you could increase your invested wealth by 370%.

Exactly when to sell will probably depend on the climate amongst the general public, with a gold-buying mania that will lead to an obvious bubble. During that mania in the gold market it will be the time to get out.

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