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:
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.
One Dow Theorist