The Dow/gold ratio made what clearly appears to be a major peak in August of 1999. The major peak of 1929 was not exceeded until 1959 and the major peak of 1966 was not exceeded until 1998. Therefore, if history repeats itself the 1999 peak will remain unchallenged until at least 2029. Furthermore, before embarking on a climb to its next major peak the ratio will first drop below 5 and will perhaps fall as low as 1. Past declines from peak to trough have occurred with greater speed than the ascents from trough to peak, so a major bottom would likely be reached before the end of the current decade.

It is all well and good to draw conclusions based purely on historical data, but are there actual reasons (other than the expectation that the cyclical pattern will continue) why the Dow/gold ratio should plunge below 5 and subsequently soar to a new high?

We can come up with a good explanation as to why the ratio is going to fall to a much lower level (see below), but we can't explain why it will necessarily fall to the lows reached at the bottoms of previous cycles. Also, we doubt that we will ever see the Dow/gold ratio trade up to its 1999 levels again, even if we live to be 150. The distortions during the late-1990s were so great that even after a 2-year readjustment period the Dow/gold ratio is still above where it was at its previous major peak in 1966.

To understand why the ratio is almost guaranteed to fall to a much lower level it needs to be understood that, over the very long term, most of the gains achieved by investing in the stock market stem from inflation and dividends. Actually, using the word "most" here is a gross understatement. More than 99% of stock market returns over the past 200 years have come from inflation and dividends. Since re-invested dividends aren't included in the Dow Industrials Index, almost the entire gain in the Dow over the past 200 years can be attributed to the effects of inflation (the loss in the purchasing power of the Dollar). A reduction in the Dollar's purchasing power will also, over the long term, result in a corresponding rise in the dollar price of gold. Therefore, the gold price and the Dow Industrials should move higher at roughly the same pace (they should, over the very long-term, maintain a roughly constant ratio).

We don't know, and it is not possible to quantify, how many ounces of gold should be needed to purchase the Dow. That is, it is not possible to calculate a fair value for the Dow/gold ratio. What we do know is that a) the ratio periodically gets pushed way above and way below its historical mean, and b) once the ratio has reached an extreme and reversed course it tends to head in the opposite direction until it once again reaches an extreme.

We can't be sure that the ratio will once again return to the 1-5 range that marked the bottom in previous cycles over the past 120 years, but the probability is very high that the ratio will fall far below its present level over the next few years. Obviously, the ratio can plunge as a result of a much higher gold price or a much lower Dow or a combination of a higher gold price and a lower Dow. Our view is that the gold price will do most of the work since we expect a depreciating US$ to underpin the Dow.

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Steve Saville
Hong Kong