Is it a good timing device?
Since this blog deals with US Stocks and Gold, and
prompted by a Subscriber of thedowtheory.com, today I’ll briefly discuss the
Dow to Gold ratio and its usefulness as a timing device.
You can find an explanation of the Dow to Gold ratio
and an excellent interactive chart displaying the ratio on any given date here.
I quote from “longtermtrends.net”
“The Dow to Gold ratio indicates the number of ounces
of gold it takes to buy the shares in the Dow Jones Industrial Average index”
This is the question posed by our Subscriber:
Jack,
You’ve
always helped me with my investing and are a sharp guy. I need your opinion on
something if you don’t mind. I was reading that a simple market timing system
that has proven very accurate over the last 100 years is the dow/gold ratio.
When the ratio is above 15 it’s time to buy gold(now @ 14.8) and when it’s
below 5 it’s a good time to buy the stock market. There would have been only a
handful of trades in the last 100 years. In 1999 the ratio was 41 and gold took
off in the 2000’s. Do you know anything abt this? Is it worth exploring? Pls
advise. Thx Jack and I hope you and your family are during the covid lockdown.
This is the
answer we gave to our Subscriber. While not a treatise on the Dow to Gold
ratio, I feel it may be helpful to the readers of this blog:
My two cents on the Dow/Gold
ratio (DGR, hereinafter).
Any trading system
based on past parameters looks great. However, when looking forward such
parameters tend to fail miserably. So there is no guarantee that buying gold at
a DGR of 15 and selling it (and buying stocks) at 5 will work in the future.
I was an avid student
on the DGR. Eventually, I dropped it as a timing device and opted for the Dow
Theory. If gold is going to go up, the Dow Theory will let me know and the same
applies to stocks.
The “ride” from 15 to
5 may be a bumpy one with horrible drawdowns in between. Is one willing to
stick to the trade through thick and thin?
Furthermore, the
ratio does not contain a “stop-loss”. What if both stocks and gold decline
(i.e. due to deflation)? Are you going to hold gold until you reach 5? What if
a GDR never reaches 5 or takes 30 years to do it?
In 2007, in real-time, I remember one article that advised buying gold based on a GDR around
16-17 based on the premise that until 2007 “stocks
had an 18 year bull market”. The article went on to say: “Unfortunately for the stock market bulls,
asset classes go in and out of favor, and the next great asset class may very
well be gold”. Well, even taking
into account the 2008-2009 bear market (which would have been mitigated by the
Dow Theory), stocks have continued to go up for the last decade. By the way,
the 2008-2009 bear market also affected gold which endured a drawdown of ca.
30%. So the good ratio for gold prevailing in 2007 did not prevent gold from
declining. Furthermore, when gold reached its top in 2011 the ratio stood at
ca. 6.8, which, according to the system you suggest, would not have been a
“sell” signal. In other words, you would have to endure a huge drawdown by not
selling in 2011.
The ratio may be
useful in order to superficially gauge whether gold is cheap or dear relative
to stocks. And I write “superficially” because I have my qualms as to the
rationale of the ratio. It’d be too long to explain why I feel the ratio is not
carved in stone. Here suffices to say that the more prosperous a society becomes
(more capital invested per head) the higher the discount (PER) for stocks,
which implies higher values for GDR and more difficult to reach lower values.
Having said this, if
I saw an extreme value such as 3, and the trend of gold was bullish under the
Dow Theory or even a long term moving average, then I might make a speculative
commitment. However, aided by the Dow Theory, I’d have my stops in place.
My final thought on
gold is as follows: There is gold for speculation and gold as a long term,
insurance-like, holding. I –contributing editor- own some physical gold. Such a
gold is not subject to trading. It sits idle as an insurance against many
unknowns (demise of the US dollar? Reset? Debt repudiation?). The gold for
speculating is not physical. It is the kind of GLD. The gold for insurance is
the one that sits quietly on a vault in a safe jurisdiction. Two different
beasts.
That’s all for today.
Sincerely,
One Dow Theorist
