The Dow to gold ratio has been favored by traders as an excellent way to find overbought and oversold levels on the United States’ most popular index. Using the Dow to Gold ratio provides traders with insight into finding the best times to buy and sell both gold and stocks in a rapidly changing economy.
True Inflation Indexing
When speaking in nominal terms, it’s hard to identify the oversold and overbought levels of the Dow. If the Dow were to gain 500% one year with 1000% inflation, the index would be a great buy; however, an ordinary chart would look like an easy-to-call top. Gold's ability to track inflation has been impeccable: since 1913, the dollar has lost 96% of its value and gold has moved from $35 an ounce to $900. After working out the math, you would find that the true price of gold should be $875 per ounce, quite in line with inflation. The difference is minuscule considering a 96 year tracking period.
How the Dow to Gold Ratio Works
The Dow to Gold ratio is just like a PE ratio. The ratio is the amount of ounces of gold it would take to buy the Dow. For instance, if gold is $900 an ounce, and the Dow is trading at 8000, it would take roughly 8.9 ounces of gold to buy the Dow.
A Historical Look
The Dow to Gold ratio has made three large peaks over its history, with the first one occurring in 1928 at a ratio of 18:1, another peak in 1965 at roughly 28:1, and again in 1999 at a ratio of 42:1. Over time, the highs for the Dow to Gold ratio have only grown higher, and interestingly enough, each new high has been around 50% higher than the peak before it. Keeping in line with this pattern, in the future, the next peak could occur at 63:1. (42 x 1.5 = 63)
The Universal Bottom
Although the ratio has varying tops, it also maintains a very similar bottom. For instance, after the Great Depression, the Dow to Gold ratio fell to rest at a rate of 3:1. In contrast, in 1980, at a time experiencing record highs for Gold and a terrible economic environment, the ratio rested around 2:1. After a large economic boom, the Dow to Gold ratio has always fallen to an adequate level between 1-3:1. Currently, the ratio resides at a value of 8.6:1, well off its highs, but not low enough to call this a bottom.
Reading the Ratio is Easy….Trading it isn't
Finding to Dow to Gold ratio is easy, but trading it is not as simplistic. Due to the way that the ratio works, one of the two elements could change in price drastically and have a similar effect on the ratio. For instance, at the current ratio of 8.6:1, a 20% gain in gold with no change in the price of the Dow would bring the ratio to 7.17:1. However, if gold rose 20% and the Dow were to drop 20%, the difference would be even bigger at 5.7:1.
Buying and Selling
Generally speaking, a high Dow to Gold ratio is representative of an overpriced stock market and underpriced gold, whereas a low ratio would mean an underpriced stock market and overpriced gold market. The problem in this basic ratio is that there is no way to tell which side of the position will outperform the other. Should you short the Dow or buy gold at a high ratio? Though the generalization above is true, the largest movements are up to the market. Investors can't know which way the market will go beforehand, but having a general idea can certainly point you in the right direction.