Follow The Bottom Violation
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Mar
22
Dow, Dollar, and Gold Parity: What Does It Mean for Value Investors?
Over the past year or so, I have been paying a lot of attention to the relationship between The Dow Jones Industrial Average and the price of an ounce of gold – which is commonly expressed by the Dow-to-gold ratio. On the surface, the ratio seems simple enough; if the Dow is at 10,000 and gold is at $1000 an ounce, the Dow/gold ratio is 10. Likewise, if the Dow is at 2000, and gold is at $2000 an ounce, the Dow/gold ratio is 1. But if you think about it, the relationship contains more than the two obvious components — the DJIA and gold; the equation also employs component most people tend to overlook, which is the dollar. And once you consider the Dow/gold ratio from this perspective, the added dimension has all sorts of thought-provoking, and even frightening implications.
Before we delve further into the Dow/gold ratio — and the somewhat concealed role the dollar plays in its formation — I want to talk about the performance of the Dow, alone, over the last 80 years. Many analysts and economists have been comparing our current economic fiasco to the Great Depression, suggesting that this downturn may be as bad, or even worse than that period’s. On that note, I want to point out that, in 1932, the DJIA bottomed after losing almost 90% of its value; as of the close of business on March 20, 2009, the Dow is down 49.5%. If the stock market is heading for a bottom similar to the 1930s crash, we have a long way to go; the Dow’s high, in October of 2007, was around 14,150. If it loses 90% of its value, it will stand at a value of 1415. A lot of people believe that is precisely where the DJIA is headed, and philosophically, I agree. But, as with everything else in this terrifying time, nothing is as simple as it looks, and searching for an absolute value of 1415 on the DJIA could be a costly mistake.
In recent months, I’ve pointed out some fairly startling differences between this economy and the Great Depression. For starters, in the 1930s, the U.S. was a creditor nation; it essentially borrowed its way out of the Depression, and while I believe that was a mistake — only prolonging the pain — it was, nonetheless, one (very costly) solution. Unfortunately, the country’s current status as the world’s largest debtor nation precludes it from employing that strategy again – although Ben Bernanke, along with Barry Obama’s economic toadies, would have all of us believe it can work. If you buy into that theory, however, I want to remind you that the government is printing money and easing credit at an unprecedented rate. Sure, the prices of most asset-classes are falling, but that’s part of the solution, not part of the problem. The U.S. government, however, wants you to believe that the only cure to this disease, brought on by decades of inflationary money-printing and easy credit – which inevitably led to malinvestment, unprecedented economic volatility, and ultimately, several horrific economic collapses – is yet again to expand the money supply and to further ease credit until the U.S. consumer resumes his relentless and irresponsible plight to spend, rather than to save. I’m at a loss as to how anyone of a sound and rational mind can honestly believe that the solution to this type of economic catastrophe is yet more borrowing and spending. It’s like saying the cure for heroin addiction is an overdose. It’s preposterous.
Granted, I am a dyed-in-the-wool Austrian economist, and our definition of inflation is always the printing of money coupled with the creation of easy credit. Some of you are, of course, aching to extinguish my fire with a hose-full of Keynesian dogma, and to that I say, do your worst. But remember this: Keynesian theory – which its own author repudiated – has been around less than a century, but empires have been crushing themselves under the weight of their own reckless piles of printed money for eons. Bernanke claims he can tame rising prices when they return – and they will return, with a vengeance. But how on earth can he possibly believe he can control rising prices? How will he reel in the dollars he and his gaggle of sycophants are so capriciously printing? Will he sell Treasuries? To whom, and at what yields? Does he really think that he can simply offload trillions of dollars of debt to the world at constant low rates? If so, he’s a fool; if he sells bonds, he’s going to drive their prices down hard, and that can only mean increasing yields! How is that going to help “tame” rising prices?
Here are a few more differences between the 1930s and our current calamity: in the 1930s, the U.S. had a significant savings rate. Today that rate swings between negligible and negative. In the 1930s, the U.S. had a huge manufacturing base; it exported far more than it imported. Today, the U.S. is, for the most part, a service economy. Its automobile industry – once world’s paradigm – is now crumbling under the weight of debt, bureaucracy, and union demands. Everything from computers to apparel is made by foreigners. Until recently, the U.S. consumer bought those manufactured goods with the money he or she borrowed from houses and credit cards – creating an economic house of cards. The house, however, has now imploded; the U.S. consumer is tapped out and cannot drive nearly 70% of the economy as it once did. And, to continue the comparison, in the 1930s, the U.S. dollar was backed by gold, which is no longer the case.
That brings me to perhaps the most important disparity between the Depression and our current situation. In the 1930s, because of all the factors I just mentioned, the United States found itself in a state of sustained falling prices. The government couldn’t print money at will – it had to adhere to the gold standard to which it was obligated. Yes, the Great Depression was horrific, but at least prices fell, and continued to fall. Today, the vast sums of money the government is printing, coupled with the unprecedented easy credit it has put in place, ensure that falling prices are only a temporary phenomenon; indeed, the government is trying to create inflation! And as bad as the Great Depression was, I don’t think any of us can imagine how much worse it would have been if the country had had to face 25% unemployment and rising prices. It’s almost unthinkable.
Almost.
In the early 1930s, after the stock market hit its nadir, it rebounded to the tune of 150% in about a year. That would suggest that a savvy investor who gets in at or near the bottom of this bear could stand to make a fortune on the rebound. Is the stock market going to lose 90% of its value? I believe it will lose that much, or maybe even more. Does that mean a DJIA of 1415? Probably not.
Let’s talk about the Dow/gold ratio again. If you look at the chart above, you can see that a ratio around 1 or 2 normally signals a bottoming of the Dow, as well as a top for gold. I say “normally” in the context of the last 80 years, in which the U.S. government has manipulated the economy and its currency successfully, time after time. Unfortunately, because of all the factors I mentioned earlier in the article – the country’s status as the world’s largest debtor nation, its status as a service economy, its savings rate, et cetera – the government has finally painted itself into a proverbial corner from which there is no escape. Skyrocketing prices are inevitable, which means – if you let thousands of years of history be your guide – gold is going much higher.
In nominal dollars, I do not believe the DJIA is going to lose 90% of its value, but in real terms, I believe it will probably lose considerably more than that. If we differentiate this economy from the 1930s in terms of the direction of prices, and we agree that, unlike the 1930s, rising prices are inevitable, then the Dow/gold ratio could approach 1 (or even go lower) even if the DJIA maintains its current level, or goes higher! In fact, if Bernanke is unable to “tame” rising prices caused by his inflationary mischief, it’s very likely gold could surpass its real-dollar peak over $2000 in the early 1980s by a tremendous margin.
So, in the 1930s, because prices fell sustainably and continuously, the DJIA did lose 90% of its value, in real dollar terms. But if inflation causes explosive price increases this time, it’s likely that, in real terms, the Dow will lose 90% or more of its value without actually falling much beyond current levels. And remember – the CPI is not the true measure of price-increases. Keep your eye on gold, as well as on things like gasoline, eggs, milk, and other agricultural products; these are the true measures of costs in our economy, and when those prices begin to increase rapidly, you will know Bernanke has failed.
As far as returning to stocks, well, my theory goes something like this: we need a way to calculate the real-dollar loss of value in the DJIA, as it relates to impending inflation, as measured by gold, and what better way to do that than the Dow/gold ratio? As bearish as I am on the U.S. economy right now, I still believe U.S. companies will be among the most innovative in the world once this all shakes out. To illustrate my point, consider some of the great German companies that survived world wars and the destruction of the Weimar mark: BMW, Bayer, and Daimler are among many more that withstood incomprehensible political and economic changes.
I am a value investor, and I believe earnings have a long way to fall before we’re finished with this debacle. Nonetheless, I’ll be watching the Dow/gold ratio carefully. Once it approaches 1 – whether that means a DJIA of 7000 or 700 — I’ll be looking at stocks very carefully.
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Disclosures: Paco is long TBT, UCO, and gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.
You can buy his novel Discipline wherever books are sold.
1 Comment so far
Partners
I’m at a loss as to how anyone of a sound and rational mind can honestly believe that the solution to this type of economic catastrophe is yet more borrowing and spending. It’s like saying the cure for heroin addiction is an overdose. It’s preposterous.
Superb.