Testing Our Dow/Gold System

Testing Our Dow/Gold System

Dear Reader,

We don’t give investment advice in these daily columns. We just try to connect the dots. And one thing we notice is that they form patterns. Hope…despair. Empire…destruction. Summer…winter. Birth…death. Money printing…inflation. One thing follows another, shaped by some age-old template.

Looking at the stock market, we see long cycles of boom and bust.

The problem with just staying ‘in the market’, may leave you with a losing position for decades. In the US, after the crash of 1929, it took 26 years for stocks to recover, in inflation-adjusted terms. And in Japan, stocks crashed in 1989; they still haven’t recovered.

Trying to ‘time the market’ rarely pays off. But rarely is good enough for us. The most dangerous periods — when stocks are extremely overvalued — are rare too. And even an imperfect system for screening them out can be remarkably helpful.

There are times to hold ‘em, in other words, and times to walk away. There are also times to run. In preview, this is a way to tell when to put on your running shoes.

What we aim to do is only to dodge the ‘big loss’. When you’re young, the ‘big loss’ may be a learning experience. But when you are approaching retirement, losing a substantial part of your wealth can be a bummer.

Lessons learned

How do we avoid it? The stock market has a lot of noise and chop. But it also has long cycles that take it from major top…to major bottom….and back to a top again. There was a top in 1929…and another in 1966. The third major top came at the end of the century, 33 years later. As we suggested yesterday, the cycle seems to roughly correspond to human generations. One learns. The next forgets…and relearns.

On Friday, we discussed using price/earnings (P/E) ratios to identify the danger zones. You might, for example, simply sell out of stocks when the average P/E goes over 20. But there’s too much irrelevant information in P/E ratios to be very helpful. In 2009, for example, in the panic of the mortgage finance crisis, the P/E ratio of the S&P 500 weirdly flew up to more than 100. You might have concluded that stocks were too expensive; actually, they turned out to be cheap. Prices rose for the next 11 years.

Another indicator is the one Warren Buffett favours: Market cap/GDP. Companies provide goods and services. They create wealth, pay wages, and then get the money back as sales revenue. So stock market value cannot get too far away from GDP. Historically, the ratio has usually been around 80% — or eight units of stock market capitalisation to 10 units of GDP. In 1999, the ratio hit a high of 140%…way above the normal range. That was a good time to sell. But the ratio now is even higher — at almost 200%, an all-time record. A simple rule: sell stocks when the ratio goes to more than 120%. That would have spared you the dotcom bubble of 1996–2001 and the everything bubble, 2016 to today.

But we have what we think is a better system. We compare the Dow (with the US’s 30 leading industrial companies) to the price of gold.

…and a refinement that greatly increases the profits, but here are the simple mechanics.

Gold is real money. It is not perfect money, because it is heavy and hard to carry around with you. But it is still the best money ever discovered.

When you compare it to the Dow, you are juxtaposing two things that are in constant opposition, like fighting bucks whose horns have gotten locked together.

The Dow represents the flower of American prosperity; gold is the age-old measure of value. The Dow is hope; gold is experience. The Dow is the future; gold is the past. The Dow is dreams; gold is reality.

Companies can create an almost unlimited amount of wealth; but there is only so much gold to measure it. So, in terms of gold, the price of the US’s top corporations (the Dow) goes up and down…but never strays too far from its long-term mean — around 10 ounces of gold to the Dow.

One century, six trades

Just go back to when the Fed was set up, in 1913. Imagine that you followed a simple rule: you bought stocks when the Dow traded for 5 ounces of gold, or less…and you sold your stocks and bought gold when the Dow sold for 15 ounces of gold or more.

Right off the bat, you would have taken your nest egg — say, US$100 — and bought stocks. They were trading at 4 ounces to the Dow in 1913. Then, they got even cheaper as the Second World War began. But you don’t have to read the news or study the claptrap put out by economists. You just stick with the system.

You sell your stocks and buy gold in 1929, when the Dow/gold ratio goes to more than 15…and buy back into stocks in 1932, when the ratio collapses to under five again.

The next move is a stock sale 27 years later, when the ratio crosses the 15 mark…followed by another buy in 1974. That is the beginning of another bull market. You stick with it until it reaches a Dow/gold ratio of 15. Then, you make your final move — selling out of stocks. You’ve been in gold ever since.

What? You missed the biggest bull market in history…from the depths of the mortgage finance crash in 2009 to today’s peaks. You also missed the glory years of the dotcom bubble — from 1996–2000. How could this be a good trade?

Well, after the dotcom crash…and the mortgage finance crash…the ratio never fell to our five target. So we never bought back into the stock market. We’ve been out of stocks for the last 26 years, patiently biding our time in gold.

And yet, with this trading system — with only six trades in the last 100 years — you would have turned 4 ounces of gold in 1913 into 17,773 ounces of gold today. Your original US$100 would now be worth about US$33 million.

The current Dow/gold ratio is 18. And by almost all other measures, US stocks are at an all-time high. Do you have your running shoes on yet?

Stay tuned…


Dan Denning Signature

Bill Bonner,
For The Daily Reckoning Australia