Reading The Dow v. Gold Ratio

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We drew upon analyst Russell Napier’s 2006 book Anatomy of the Bear in preparing our 2011 report on whether the bear market was nearing an end. Not exactly beach reading… but he does a masterly job pinpointing the factors at play at those moments when secular bear markets end… and secular bulls begin.

The bear market cycles identified by Napier don’t line up in lock step with our “fearsome foursome” chart, but after the crash of 1929, they line up almost perfectly. The inflection points Napier describes — when bear turns to bull — are in 1921, 1932, 1949 and 1982. And based on those previous market cycles, Napier’s book projected the next turn would come in 2014 — next year. (Which lines up with the 14½-year average for secular bear markets.)

But oh, what a wild ride we’d be in for between now and then. In a November 2012 presentation, Napier did not project a date… but he did say for the market to reach valuation levels equal to those earlier turning points, the S&P 500 index — currently above 1,500 — would crash to 450.

We beg to differ. Aside from the recurring pattern of lows smack in the middle of a secular bear — i.e., 1974 — we’ll cite Napier’s most compelling evidence. It’s the q ratio, or “Tobin’s q.”

This number is the brainchild of Nobel laureate James Tobin: Take the total market value of a company, then divide it by the replacement value of its assets (in other words, how much you’d pay to build the company from scratch).

You can apply the q ratio to a company or the entire stock market. Here’s our 2011 chart, updated to the present courtesy of Doug Short at Advisor Perspectives:

In every previous bear market cycle, the q ratio hit roughly 0.30 at each of Napier’s bear market turning points. Napier is convinced the next turning point will coincide with a similar reading.

We’re struck by the stratospheric reading the q ratio reached at the end of the 1982-2000 bull market — far, far higher than previous tops during the 20th century. We think it’s no accident. We think it’s the consequence of Alan Greenspan’s tenure at the Fed and his habit of loosening the monetary spigots at even the faintest hint of a crisis…

  • The 1987 crash
  • Saddam Hussein’s invasion of Kuwait in 1990
  • The 1991 recession
  • The 1994 “Tequila crisis,” when Mexico devalued the peso
  • The 1997 Asian crisis
  • Russia’s default in 1998
  • The Y2K scare in 1999

Couple that with all the money printing Greenspan and Ben Bernanke have done since 2000… and we suggest the q ratio might be moving up in a new long-term channel.

So what does that mean for the Dow, and gold and the ratio?

As we’ve written, we think the bottom is in. The level of 6,547 set four years ago this month will never be revisited. Beyond that, it becomes much harder to say. And once again, the Fed is to blame: Mr. Ritholtz says the Fed’s policies since the Panic of 2008 are a “wild card.”

Zero interest rate policy and quantitative easing “make it difficult to think of most gains as completely organic,” he says. “It also has made any comparisons to prior secular bull markets more challenging, as it introduces another variable.

“Under ordinary end-of-secular-bear market conditions,” he goes on, “I would like to see P/E ratios even lower and stocks even more hated/ignored. The Fed has disrupted those metrics, and that makes seeing the end of the secular bear all the more challenging.

“If you want a more specific forecast date for when I think it will end, my best guess is sometime between next Tuesday and 2017.”

We’ll stick our necks out a bit more in light of the Dow’s performance during previous secular bears, even as we acknowledge Barry’s caveat that we have “a decidedly small sample set” from the past century.

We reprise a chart of the bears and the bulls we published yesterday. In each of the last two secular bears, the Dow has a ceiling. We’re bumping up against the ceiling right now.

Look for a 20-25% downdraft sometime between next Tuesday and 2017. We have every expectation that the boomers who got sucked into stocks in the late ’90s… and again around 2004-05… only to get kicked in the teeth both times… and who are only now re-entering the market… will get kicked one last time.

That will knock the Dow to below 11,000… which at a 2:1 Dow-gold ratio, means gold jumps to $5,500.


Gold and Paper Money – Statements from Wise and Famous People

“When paper money systems begin to crack at the seams, the run to gold could be explosive.” Harry Browne

“Regardless of the dollar price involved, one ounce of gold would purchase a good-quality man’s suit at the conclusion of the Revolutionary War, the Civil War, the presidency of Franklin Roosevelt, and today.” Peter A. BurshreDeviant Investor

“In the long run, the gold price has to go up in relation to paper money. There is no other way. To what price, that depends on the scale of the inflation – and we know that inflation will continue.” Nicholas L. Deak

“If you don’t trust gold, do you trust the logic of taking a beautiful pine tree, worth about $4,000 – $5,000, cutting it up, turning it into pulp and then paper, putting some ink on it and then calling it one billion dollars?” Kenneth J. Gerbino

“Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” Alan Greenspan

“The first requisite of a sound monetary system is that it put the least possible power over the quantity or quality of money in the hands of the politicians.”
Henry Hazlitt

“All previous attempts to base money solely on intangibles such as credit or government edict or fiat have ended in inflationary panic and disaster.”
Donald Hoppe

“Betting against gold is the same as betting on governments. He who bets on governments and government money bets against 6,000 years of recorded human history.” Gary North

“Gold was not selected arbitrarily by governments to be the monetary standard. Gold had developed for many centuries on the free market as the best money; as the commodity providing the most stable and desirable monetary medium.” Murray N. Rothbard

“Gold will be around, gold will be money when the dollar and the euro and the yuan and the ringgitt are mere memories.” Richard Russell

“The history of fiat money is little more than a register of monetary follies and inflations. Our present age merely affords another entry in this dismal register.”
Hans F. Sennholz

“For more than two thousand years gold’s natural qualities made it man’s universal medium of exchange. In contrast to political money, gold is honest money that survived the ages and will live on long after the political fiats of today have gone the way of all paper.” Hans F. Sennholz

“The gold standard, in one form or another, will prevail long after the present rash of national fiats is forgotten or remembered only in currency museums.”
Hans F. Sennholz

“You have to choose [as a voter] between trusting to the natural stability of gold and the natural stability and intelligence of the members of the government. And with due respect to these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.” George Bernard Shaw

“As fewer and fewer people have confidence in paper as a store of value, the price of gold will continue to rise.” Jerome F. Smith

“With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.” F.A. von Hayak

“Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money.” Daniel Webster

(Thanks to Investment Rarities)

GE Christenson
aka Deviant Investor