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Dow/Gold Ratio = 1 at $3000: Don't Laugh!

November 22, 1999

From an historical perspective, the possibility that the Dow Jones Industrial Average and the gold price could converge at around $3000, i.e., the Dow at 3000 and gold at US$3000/oz. sometime in the next decade is quite supportable. Nor does this possibility invoke Y2K disruptions, terrorist events, or any other unanticipated geopolitical disturbances. But adding them to the analysis might have produced an even more catchy heading: Dow and gold at $2000 in 2000. Then again, with luck maybe the Dow/gold ratio will next bottom at 2 or 3 with gold at $2000 or $3000 and the Dow at 6000. Traumatic as that sounds, it is well within historic parameters.

Many think that gold peaked in January 1980 at just over $800/oz., or around $1600 in today's dollars. But according to a charticle in Forbes (May 4, 1998, p.50), gold hit its all-time high in 1492 at around $2400 in current dollars. That the real price of gold peaked in the year that Columbus sailed for America is not wholly coincidental. Over the next century, as the Europeans plundered the gold treasure of the New World and transferred it to their own economy, the real gold price declined to a level that notwithstanding periodic wild oscillations has remained remarkably stable from Shakespeare's time to the present day. Roy Jastram makes the same point in more academic fashion in the The Golden Constant (see Reading List).

From the start of the industrial revolution to World War I, constraints of the classical gold standard that might have forced a real upward revaluation of gold were eased by several great gold discoveries, first in California and Australia, later in the Yukon and above all, South Africa. As another Forbes charticle (Jan 12, 1998) points out, the twentieth century is unique for a consumer price explosion averaging almost 3% annually in the U.S. and a worldwide paper standard of value. But the century of global war and global inflation has also produced a global economy in which large national economies that formerly had little or no connection to those of America or Europe now impact them directly.


s the new millennium approaches, any extraordinary changes in gold supply relative to worldwide monetary demand appear more likely on the demand side of the equation. Perhaps there is another Eldorado waiting to be found, but the declining gold prices of the past decade have not encouraged the search. At the same time, the trend of monetary demand from Asia is increasing and looks to do so for the foreseeable future. Most Asians have a strong historic and cultural affinity for gold, an appetite further whetted in recent years by crummy paper currencies based on mostly western ideas: central banking, floating exchange rates and IMF policies. With literally billions of smart, industrious people just entering the world economy, Asia could be to gold demand in the 21st century what the New World was to gold supply in the sixteenth.

The Dow/gold ratio is virtually useless as a short term indicator. Rather, its logic and utility relate to the great cycles of the international economy. The Dow is a standardized measure of the value in U.S. dollars put on ownership of the leading American businesses of the day. Although the companies in it change at the discretion of its proprietor and are not weighted for capitalization, the Dow tracks quite closely with the S&P 500. Gold is permanent natural and international money. All over the world, people can tell you the gold price in their own currency even though they may have little or no idea of the local price of other currencies. While the Dow is more affected by the domestic credit environment, gold is affected by both national and international monetary and credit conditions. Thus the Dow/gold ratio gives an international perspective on the value of U.S. stocks that purely American indices cannot provide.

The Dow/gold ratio moved from 1.01 in 1897 to 18.4 in 1929 before the crash, then fell to 2.01 at the bottom in 1932 (gold fixed at $20.67/oz.). From 28.26 at the Dow peak in 1966 (gold fixed at $35/oz.), the ration fell to about 3 at the bottom in 1974, and to 1.04 in January 1980 at the modern peak in gold. At the Dow's peak in August 1999, the ratio was over 40, an all-time high. Portrayed on a chart covering this century, the Dow/gold ratio presents a violent saw-tooth pattern that would scare a roller coaster fan. For a long term Dow/gold chart, see; for charts since 1984, see The peak ratios of 1929 and 1966 both resulted from credit expansions that ultimately strained the existing international monetary order to the breaking point. The 1932 and 1974 troughs in the ratio coincide with those breakdowns, events virtually unavoidable in retrospect but not widely anticipated in advance.

The circumstances of the 1929 and 1966 peaks have three features in common: (1) an unreasonably low official gold price relative to monetary demand; (2) a multi-year domestic credit expansion beyond anything previously known; and (3) a pervasive feeling of optimism and perpetual prosperity. The unrealistic gold prices largely reflected the stigma attached to devaluation and official distaste for embarrassment by gold. The credit expansions were facilitated by government monetary policies rooted in the demands of wartime finance, but permitted to come to full flower only in the relaxed atmosphere of the subsequent peace. And in both periods, unbounded faith in the future came amidst astonishing technical and scientific advances. All these conditions are present today.

Although the gold price is no longer fixed by government decree, the Bank of England's gold sales are inexplicable except as part of what has likely been a multi-year effort by certain governments and central banks to keep a lid on the gold price. As discussed in prior commentaries, these official manipulations no longer command the support of the ECB and other European central banks, leaving the BOE and the Fed with the job of cleaning up a market mess mostly of their own making. The public announcement by Kuwait that all its official gold reserves are now available for lease through the BOE is part of this effort. Historically, extraordinary ferment in the gold market caused by unusual government disposals or acquisitions are indicative of peaks in the Dow/gold ratio.

However, official distortion of the gold price today is not limited to these more recent interventions. A far more fundamental distortion was created by the 1978 amendments to the articles of the IMF seeking to oust gold from the international monetary system and largely to replace it with U.S. dollars. When the dollar can no longer support this international burden, the suppression of gold will likely unwind with the force of a coiled spring.

Egregious departures from historical standards of stock valuation and prudent financial practice are characteristic of all great bubbles, and thus also of peaks in the Dow/gold ratio. Many analyses support the proposition that stock valuations now exceed historical norms by wide margins.

Although not added to the Dow until only a couple of weeks ago, Microsoft as measured by stock market capitalization is the world's largest company. Even after its antitrust setback and despite the obvious new challenges it faces, it continues to trade at a trailing PE around 60, nearly twice both its 5-year earnings growth rate and its average annual PE as reported by Value Line. It pays no dividend and has a book value around $5, but these criteria are deemed of no relevance at all in the current new era. In a recent online analysis (, a Portland, Oregon, investment firm contends that under proper accounting practices, Microsoft is not even profitable. It is not necessary to accept this startling conclusion to appreciate two fundamental and very real problems that this study points up.

The first is the effect of stock options on reported wage expenses, particularly in the technology sector. In a bull market, employees are willing to take stock options in lieu of salary. When exercised, the employee is taxed on the basis of market value. That is, the difference between the exercise price and the market price is treated as income, on which the employee is then taxed regardless of whether the stock is sold. The market price thus becomes the new basis for future capital gains taxes. The company takes an income tax deduction equal to its tax rate times the employee's calculated income, but typically records no corresponding charge to earnings on its P&L. Thus, while the newly issued stock causes dilution in per share earnings, the wage or salary expense that it represents -- the difference between the market price at issuance and the exercise price -- does not impact earnings and increases reported cash flow by the amount of the tax deduction.

Whatever one thinks about the accounting conventions that apparently allow this treatment, it is clear that companies compensating large numbers of important employees in this fashion are headed for significant financial and personnel problems should their stock prices merely level out, never mind fall. What is more, this situation produces substantial incentive for companies to try to push their stock prices ever upwards by managing earnings, repurchasing shares, or in Microsoft's case even selling put options to institutional holders of large blocs of its stock. Indeed, sale of put options has in recent quarters generated a not insignificant amount of cash for Microsoft while allowing some of its largest shareholders to enjoy at least the illusion of protection.

The second problem underlined by the Microsoft study is the danger of stock indexed investing done with no regard to underlying stock values. The 1972-1974 bear market, which took the Dow from over 1000 to under 580, ended the "Nifty-Fifty" era and discredited the widely held belief that smart investing consisted merely in buying and holding a few blue chip or so-called "one-decision" stocks. As a practical matter, this belief is reincarnated today under the guise of index investing, a perfectly valid and useful concept until taken (or gamed) to nonsensical extremes. Throwing funds at capitalization-weighted indices while remaining blind to the underlying value of their largest components has produced extreme overvaluations in certain "gorilla" stocks.

Like Microsoft, many of them are technology stocks, allowing their "new era" aura to trump more mundane considerations relating to profitability and sustainable growth rates. Among the Dow stocks, they now include after the recent changes: AT&T, Hewlett-Packard, IBM, Intel, SBC Communications and Microsoft. Others include: AOL, Cisco, Dell, Lucent, MCI Worldcom and Sun Microsystems, six stocks which on November 15, 1999, had a total combined capitalization just over $1 trillion, a mean PE ratio over 65, and an average PE ratio over 100.

Industrial and consumer stocks, too, have been swept up in the indexing mania. More than anything else, index investing explains why General Electric, the next largest stock based on capitalization after Microsoft and also a Dow stock, can trade at a trailing PE over 40 when until 1996 it almost never traded at an average annual trailing PE exceeding 15. What is more, not one of its historic or projected growth rates (sales, cash flow, earnings, dividends or book value for the past 10, 5 and next 5 years) as reported by Value Line exceeds 15%.

A few months ago an experienced investment manager asked rhetorically in a Barron's interview: "Who is going to buy GE at a PE over 30?" Now he has his answer: index investors, the same people who buy other gorilla stocks at eye-popping PE ratios. Who are these index investors? Many of them are the country's largest pension funds, making the prospect of fair valuation in the largest cap stocks so unnerving as to render a bear market virtually unthinkable. According to the Microsoft study cited above, the California State Teachers Retirement System owns more than 16 million Microsoft shares with a value of about $1.4 billion based on its commitment to indexing against the S&P 500, of which Microsoft accounts for about 4%. Unfortunately, particularly in the investment world, "unthinkable" and "impossible" are not the same thing.

These, then, are the three factors that make convergence of the Dow Jones Industrial Average and the gold price at US$3000 possible before 2010: (1) the prospect of a millennial change in the gold supply/demand equation brought on by the demographics of worldwide economic growth; (2) a stratospheric Dow/gold ratio, reflecting enormous credit excesses in the U.S. but masking conditions of severe international monetary stress and ferment; and (3) unprecedented U.S. stock valuations reaching truly bizarre levels for some very large companies.

The Dow/gold ratio is signaling acute danger. History suggests that when it turns, as it may be just starting to do, the descent is not only swift and violent, but also unlikely to end short of fundamental change in the worldwide monetary order. The new millennium could well start with a ferocious financial roller coaster ride spanning the planet. Hold onto your hats, your stomachs, and the gold coins in your pockets!

Reg Howe
[email protected]

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