Sunday, October 6, 2013

Getting to ONE: the Dow / Gold Ratio

I've written about the Dow / Gold ratio several times noting that there seems to be a long term cycle where the ratio hits one or nearly one. We were quickly moving back toward a ratio of one when the Fed embarked on Quantitative Easing to reflate the Dow and then in 2011 began to intervene in the gold markets to keep the dollar relatively strong and the gold price week. Though the economy wallows in low growth recession/depression the Fed has been successful in reflating the Dow and knocking down the price of gold. But Fed intervention loses its efficacy the longer it drags on requiring ever larger amounts of dollar printing to keep the prices from reverting to their natural equilibrium.

Its my belief, this is unavoidable and eventually either the forces of inflation will over power gold's manipulation or the Dow must decline towards its intrinsic value once the collective minds of the market admit there is no recovery. Today I examine commentary from Jim Rickards and Richard Russell who are both legends in their own right. One examines gold and how it gets to $5,000 and one who examines the Dow and how it reverts to 5,000. In essence, together, how the Dow/ Gold ratio gets to one

First Jim Rickards on gold (click link to read entire interview, its very worth while):

HAI: What are your thoughts on gold after this year’s plunge? Is the bottom in? And can prices hit new highs again sometime in the future?
Rickards: Sure. The thing with gold is that it’s really just the inverse of the dollar. If the Fed tapers, and we go into recession and serious deflation takes hold, you could see gold going lower in nominal price, although it might very well outperform other asset classes in real terms. If gold went to $1,000, and the S&P 500 went to 700, what would you rather have, gold or the S&P? I’d rather have gold.
Gold doesn’t operate in a vacuum. I could see gold going lower, not because it’s not fundamentally an attractive asset, but because of Fed blunders. However, gold will find support because the Chinese are not done buying it. They need to buy a lot more. Every time gold dips, there’s massive physical demand.
If you’re in the paper market on the short side, you’re more and more vulnerable to a short squeeze, because physical gold is moving very rapidly into strong hands that don’t want to sell it. Inventories are being drawn down, the GLD ETF vaults are being drawn down, and physical is getting harder and harder to find. As long as you have a paper market, then it looks good from the outside. But if the paper longs ever decided they wanted physical, you’d find the makings of a classic short squeeze. And so that could cause gold to spike on a technical basis.
And then, longer term, over three years or four years, we’re looking at a much more serious risk of financial panic and collapse and a rise in gold to significantly higher levels. I would say $5,000 to $7,000 an ounce wouldn’t surprise me.
So gold could progress to $5,000 as the currency wars heat up but as Rickards notes, also on CHines buying:

HAI: You touched on the fact that Asian demand for gold is surging. Why do you think that is? Do they know something that we don’t?
Rickards: They know we’re out to cheapen the dollar. They’re overallocated to dollars. They know that the United States has no way out of its debt problem except by inflation. And why would you want to hold dollars -- $3 trillion worth of U.S. dollars -- in a world where the Fed is going to try to inflate its way out of a debt crisis? The answer is that you wouldn’t.
I recommend gold to my clients and I buy gold myself. I can’t account for everyone else; if people don’t get it, then good luck. But it’s pretty easy to see what's going to happen.
Now, switching to Richard Russell on the Dow:

 Richard Russell:  “This site will be about the Dow formation that we see below.  This formation is known as the “megaphone formation” or the “broadening formation.”

The broadening formation is indicative of a market in turmoil, with sentiment swinging wildly from one way to the other.  Incredibly, the broadening formation has appeared in every major bear market since 1929.  It appeared prior to WWII in 1929.  It appeared in 1957 and 1965-66.  We saw a broadening top in 1987 and again in 1998-2000.  The most recent broadening formation we saw was in 2004 to 2008.

I have long speculated about the sentiment basis of broadening formations.  Each broadening formation is made up of three rising waves and two corrective waves.  As far as sentiment is concerned, I believe broadening formations are the result of wildly swinging reversals in sentiment from bearish to bullish -- and then bearish, and finally a huge swing back to extreme bullishness.  This final wave of optimism is the market's kiss of death, since this final rising wave takes stocks far above known values.

The current broadening formation is unique in that it is, by far, the largest broadening formation that I have ever seen.  Note that wave D to E has not yet touched the upper trendline.  Frankly, I don't know whether it is necessary for the Dow to make contact with the upper trendline in order to complete the formation.

If the Dow is to touch the upper trendline of the formation, the Dow will have to advance to at least 16,000, which would be an all-time high.  An interesting thesis here is that earnings alone are not the reason for the Dow advancing.  What is driving this market higher is an increase in price/earnings.  In other words, earnings have not been rising, but what has been boosting the market is investors’ sentiment.  Investors have been increasingly bullish on the market, and therefore, they have been willing to pay more and more for the same amount of earnings.

I've written about this before.  The major swings in stock prices are often a result of drastic changes in the price/earnings ratio.  Investors become too bullish or too bearish about stocks.  When they become too bullish, this thrusts stocks into the dangerously overvalued zone.  The opposite is true when investors become too bearish.  Charles Dow wrote that unless there was some special reason, stocks were overvalued when dividends sank below 3.5%.

Back to the broadening formation:  In past cases, the bear market associated with a broadening formation carried to the lower trendline of the formation.  So let's consider that the current broadening formation follows the typical pattern.  In that case, we might expect the Dow to top out anywhere from its current position to a level around 16,000 or even a bit higher. 

Assuming that a major bear market will begin from wherever the Dow tops out, we can assume that the Dow will decline to at least the right end of the lower trendline of the broadening formation.  If that holds true, then we can expect the bear market will take the Dow down to at least 5,000.  That would represent a horrendous loss, although not nearly as bad as the 1929 to 1932 bear market.

I've searched my mind to try to understand what a bear market to Dow 5,000 might mean.  In the first place, I think such a bear market could involve a new monetary system.  I also think a huge bear market would see the balance of international power shift from the US to China.  Finally, the giant megaphone formation that I show could be an advance message to the effect that we must all be ready for massive and radical change.
 So between these two scenarios we could reach a Dow /Gold ration of one. Of course the timing of such an event is difficult to time. It also must be considered that if the Fed printing(QE) accelerates because of a weakening economy from $85 billion per month to something larger, then the two could meet at a much higher number than 5,000. This would be a reflection of a serious devaluation of the USD.

Future Fed policy is unknowable but economic history shows time and again that markets will eventually revert to their intrinsic value irregardless of attempts at market intervention, like we've seen from the US Fed over the past five years. We cannot know if the Dow price will be inflated by a cheaper dollar due to more printing(moving the price up) or whether the Dow will fall to its intrinsic value (based on today's dollar value). We do know that gold is historically under priced relative to the US debt level that it has historically been tightly correlated with.

A conservative investor would own gold for wealth preservation. A speculator would trade the Dow based on anticipated Fed actions.

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