Yes, You've Seen This Before

I've shown the Dow/Gold ratio before and discussed the reversion I expect to see back to 1:1 but its always interesting to hear others much smarter than me discuss it. Today Mike Krieger re-examines the ratio. From Zero Hedge:

What this chart shows you are secular swings in the economy.  You see how stocks ran up in real terms into the 1929 crash and then plunged versus gold.  You see how they ran up in the next great post- WW2 period into 1968 when they once again plunged versus gold.  Then you can see the great secular bull market in stocks from around 1982 to the bubble peak in 2000.  In both of the prior two periods (one deflationary and one inflationary) the DOW/GOLD ratio got down to about 1:1.  It has been my contention for many years that we will see that same ratio once again.  That would imply another roughly 75% drop in stocks to gold and I expect that this next leg is beginning now.

At any point in time the market can either make you look like a genius or an idiot. Last Monday I noted in a post that it was a good time to buy gold given that fundamentals were stronger than ever even as the price was two standard deviation below the mean. Gold is up about 3% since that post but is still down 8.8% year over year. My point here is that I have no idea what gold is going to do over the short term. I may look smart one day and dumb a month later, The fundamentals however are unchanged from day to day. Keep an eye on the longer term trends. Namely, keep in mind:

1. We're still inching closer to a fiscal cliff.
2. Central banks are still buying gold, especially in the East.
3. Some form of QE is still likely in some form.
4. We still have negative real interest rates.
5. The Euro is still in trouble with members likely to abandon the currency in the next 6-18 months.

I have no idea if this week's rally will continue or not in the short term or not, but I am quite confident that global economic forces are going to push the Dow/Gold ration lower, and quite possibly as far as 1:1. As I've mentioned before,  there will be a time to begin moving from gold back into equities, but I don't expect this to be anytime soon.

Until then, if you must invest in stocks, seek dividend paying stocks. In your 401k they are often called "Growth and Income" funds.

Is Gold Still a Good Investment?

Days like today can be frustrating. With gold dropping $45 in a single day not too long after the Leap Year Massacre, its fair to ask: Has something changed in gold? And when will it be time to sell?

Back in January I discussed real vs. nominal interest rates. Its an important concept to understand because the dollar is not a constant. Rather, it is a deteriorating asset. Casey Research recently tackles the above questions and shows that negative real interest rates are gold's best friend. If you haven't read the January post I would suggest you read it first then read Casey Research in the post below.

Gold's Critical Metric
There are many reasons why gold is still our favorite investment – from inflation fears and sovereign debt concerns to deeper, systemic economic problems. But let's be honest: It's been rising for over 11 years now, and only the imprudent would fail to think about when the run might end.

Is it time to start eyeing the exit? In a word, no. Here's why.
There's one indicator that clearly signals we're still in the bull market – and further, that we can expect prices to continue to rise. That indicator is negative real interest rates.

The real interest rate is simply the nominal rate minus inflation. For example, if you earn 4% on an interest-bearing investment and inflation is 2%, your real return is +2%. Conversely, if your investment earns 1% but inflation is 3%, your real rate is -2%.

This calculation is the same regardless of how high either rate may be: a 15% interest rate and 13% inflation still nets you 2%. This is why high interest rates are not necessarily negative for gold; it's the real rate that impacts what gold will ultimately do.

What History Tells Us
The chart below calculates the real interest rate by extracting annualized inflation from the 10-year Treasury nominal rate. Gray highlighted areas are the periods when the real interest rate was below zero, and as you can see, this is when gold has performed well.

(Click on image to enlarge)

Gold climbs when real interest rates are low or falling, while high or rising real rates negatively impact it. This pattern was true in the 1970s and it's true today.

A closer study of this chart tells us there's actually a critical number for real rates that seem to have the most impact on gold. Take a look at how gold performs when real rates are at 2% or below.

(Click on image to enlarge)

The reason for this phenomenon is straightforward. When real interest rates are at or below zero, cash or debt instruments (like bonds) cease being effective because the return is lower than inflation. In these cases, the investment is actually losing purchasing power – regardless of what the investment pays. An investor's interest thus shifts to assets that offer returns above inflation… or at least a vehicle where money doesn't lose value. Gold is one of the most reliable and proven tools in this scenario.

Politicians in the US, EU, and a range of other countries are keeping interest rates low, which, in spite of a low CPI, pushes real rates below zero. This makes cash and Treasuries guaranteed losers right now. Not only are investors maintaining purchasing power with gold, they're outpacing most interest-bearing investments due to the rising price of the metal.

Here's another way to verify this trend. As the following chart shows, from January 1970 through January 1980 gold returned a total of 1,832.6%. This is much higher than inflation during that decade, which totaled 105.8%.

(Click on image to enlarge)

In the current bull market, gold has gained 556.3% since 2001, while inflation has thus far totaled 30%.

(Click on image to enlarge)

Further supporting this thesis is the fact that when real rates are positive, gold has not performed well. You can see this in the following chart of when real interest rates were higher than inflation.

(Click on image to enlarge)

The gold price fluctuated between $300 and $500 for the twenty-year period when rates were positive. This is a strong reminder that bull markets don't last forever – even golden ones – and that at some point we'll need to sell to lock in a profit.

So if history demonstrates that gold does well during a negative-rate environment and poorly during positive periods, the natural question becomes…

How Much Longer Will Negative Real Rates Last?
US Federal Reserve Chairman Ben Bernanke stated in January that he expects to keep short-term interest rates close to zero "at least through late 2014." This low-rate, loose-money policy is intended to "support a stronger economic recovery and reduce unemployment." While his strategy is debatable, this implies that almost any inflation at all will continue to keep the real rate negative and thus gold will stay in a bull market.

What if the economy improves? After all, there are economic data showing the economy may be finding its footing, making some believe interest rates could be raised earlier, as soon as next year. Based on the data above, the answer to the question is, "What does inflation do?" In other words, interest-rate fluctuations alone aren't important; it's how the rate interacts with the inflation rate. If inflation simultaneously rises and keeps the real rate negative, we should expect gold to remain in a bull market.
With the obscene amount of money that's already been printed, high inflation seems almost certain at some point, even if there isn't any more money creation. This is why we think the end to the gold bull market is not yet in sight.
One more point. You'll notice in the above charts that this trend doesn't reverse on a dime. It takes anywhere from months to years for investors to shift from interest-bearing investments to metals – and vice versa. And the longer the trend, the slower the change. Real rates have been negative for a decade now, and with broad institutional investment in gold largely still in absentia, it seems reasonable to expect that the trend in gold won't shift anytime soon.

Implications for Investors
Armed with these data, there are definite steps you can take with your investments at this point, as well as reasonable expectations you can have going forward:

1. You can buy gold today. As long as real interest rates are negative, gold will remain in a bull market. If you already own some gold, you can and should ask yourself if it's enough at a time when money in the bank is a losing proposition.
2. Don't get flummoxed when you hear talk about rising rates. Watch the real rate instead.
3. In our opinion, real rates will be negative for some time for the simple reason that we think inflation will be rising for some time. Ask yourself: Will the Fed and other central banks raise rates aggressively enough to catch up to inflation? Someday, sure… but not anytime soon.
4. When real rates turn positive, especially above 2%, it may be time to sell. We'll have to see what's going on in the world at that time; if there's financial chaos, the fear factor could cause gold to depart from this historic pattern. But even if not, keep in mind that while the price of gold fluctuates every day, the shift out of gold-based investments won't occur overnight. There should be time to gain clarity.

There are a lot of reasons to own gold today, and there will likely be more before it's time to say goodbye. In the meantime, we take comfort in the fact that the strongest historical indicator of all tells us the gold bull market is alive and well and has years to play out.