What the Dow Says About Gold

The Dow-Gold Ratio may point to 10 years of rising gold valuations ahead...

THERE'S A LONG-TERM INDICATOR which both gold and equity investors should watch, writes Gabriel Andre for Dan Denning's Daily Reckoning Australia – the Dow/Gold Ratio.

Typically, the Dow-Gold Ratio aims to assess and forecast the potential for bullion. This indicator is built as the ratio between the Dow Jones Index and Gold Prices.

In other words, the Dow Gold Ratio tells you how many ounces of Gold you need to buy the most famous US equity benchmark.

Yes, the Dow Jones is less representative than the S&P 500. But it is more useful for calculating US business assets in terms of gold, since it has a broad historical data base dating back to 1896. (The S&P 500 was created in 1957.)

Two scenarios can generate a decline in the Dow/Gold Ratio – meaning that the US stock market is becoming cheaper for gold owners:

• The Dow Jones falls faster than the Gold Price;
• Gold Bullion rises faster than the DJIA.

This is of course the opposite way when the ratio jumps higher.

And if we look at the historical chart of the Dow/Gold Ratio (over 100 years), it appears that a declining ratio always corresponds to bearish equity markets and a rise in gold prices.

Symmetrically, a rising ratio always corresponds to bullish equity markets and falling gold prices.

Furthermore, bullish and bearish cycles in the ratio have an average duration of 15-20 years. The bearish cycles of the ratio usually end when the ratio drops to between 1 and 3.

The weekly chart shows that there is a current bearish cycle which started at the beginning of this century, corresponding to the massive rise of Spot Gold on the commodities markets.

The daily chart shows that the ratio is currently moving around 11.5. Statistically, based on the observation that a cycle lasts between 15 and 20 years, there is a further 8 or 10 years of declining ratio ahead. Only statistically, of course. Nothing is certain.

Moreover, if we go as far as to assume that the target of the bearish ratio is just 3 ounces to buy one unit of the Dow, as has been also observed statistically, it means gold prices should massively rise during the coming years. But again, that's only on a statistical basis.

For instance, a ratio of 3 means that with the Dow Jones at 9,000 points, gold would be prices at $3,000 an ounce! Or for an ounce of Gold at $2,500, it would mean a Dow Jones at 7,500 points.

You can imagine so many other different combinations...none of them pretty for equity investors missing out on gold.

But globally speaking, what does this mean? Well, if you assume that historical data across 100 years are more reliable than short-term numbers – and if you think that statistics are an interesting decision-making tool – you may conclude that the coming years are likely to be strongly bullish for gold prices.