Gold vs Stocks... The end game is near

(source: Lustre lost, Market.view, Economist.com. Feb 22nd 2009)

The graph is disarmingly simple. It simply shows the ratio of the Dow to the gold price since 1920. As can be seen, there have been three clear peaks in this ratio: in 1929, in the mid-1960s and in 2000. And it also shows three lows: in the early 1920s, in the 1930s after the crash and around the time of gold’s record high (in real terms) in 1979-1980. At those lows, the Dow and gold were almost equal.

With gold flirting with $1,000 per ounce, could we be headed there again? A Dow/gold ratio of 2 would imply the former falling to 2000 or the latter rising to $3500 an ounce. Enormous profits would be made by those who got this call right.

-- Buttonwood in Lustre Lost, The Economist

The above, from a nice article by Buttonwood of The Economist, summarizes the 90-year performance of gold in relation to stocks. The above chart is a popular one that is used by many to gauge the attractiveness of gold against stocks. It is not signalling good things for gold bulls.

Before we go further, as the article points out, there are many flaws with that chart such as the fact that it doesn't account for dividends (stocks would crush gold's returns if you compared total returns) and the fact that stocks of a growing economy should be upward sloping whereas there is no reason for gold to continuously rise (notwitstanding goldbugs' accusations of money printers populating the central banks of the world ;) ).

Given how this is a ratio chart and both the numerator and the denominator can change, it is the type that is almost useless in the sense that bulls and bears will come to different conclusions from the same chart. For instance, one may argue that the Dow is going to fall signficantly while gold stays the same so buying gold is a very good idea. Conversely, one can argue that the chart seems to be nearer the bottom than the top hence going long stocks and shorting gold is a better idea. I share the latter view and am in the gold bearish camp.

The way I look at that chart, gold is neither cheap nor is it out of favour. Gold should have been bought in the early 2000's. I do see gold going up while stocks decline a bit further. However, I feel that one thing is certain: one going long stocks right now will likely beat one going long gold in the long run.

It's too early to be bearish on gold; it is also too late to be bullish.

Regardless of whether one is bullish on gold or not, I suspect everyone will agree on one thing with Buttonwood: enormous profits are to be had for those getting this call right.