HowWealthWorks.com

[Dave]

In a related article I wrote that the final phases of a bull market provide the largest gains (steepest part of the curve).

Suresh has suggested (and I whole heartedly agree) that we time the PM market by looking at the historic ratios of gold & silver to other asset classes to identify our exit points. For example, back in '81, the dow/gold ratio was running around 1.8. 1.8, that's a number. If the number were 1.8 today, gold would either be at $6000 or the Dow would be 900. 900. That's a number.

I propose that we wait until gold enters a target asset class ratio, and time the market based on the steepness of the gold price curve (i.e., have a target for the steepness of the curve, at which point we sell).

Any thoughts?

[Suresh]

Another indicator that may be considered to determine whether gold is overvalued is the gold/oil ratio. Historically, the gold/oil ratio has averaged 15.4, according to Zeal LLC.

Consider Zeal's gold/oil ratio chart. Around 1973-74, the gold/oil ratio exceeded 30. Around 1986-87 and again in 1989, the gold/oil ratio exceeded 25. Currently, the ratio is under 9.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

An example of a Dow/gold ratio chart can be found at Fred's Intelligent Bear Site.

It looks like the intermediate lows of the Dow/gold ratio curve are roughly 2:1 around 1932, roughly 3:1 around 1974, and roughly 1:1 around 1980.

The intermediate highs of the Dow/gold ratio curve are roughly 18 around 1929, roughly 28 around 1966, and roughly 43 around 2000.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

What A Fool Believes
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[The following is a bullion marketer's rebuttal to Rich Smith's Motley Fool article entitled "3 Things to Know Before You Buy Gold."

Myth No. 1: Gold is predicted to go to $1,800 an ounce

I agree that unsubstantiated opinions about future prices of anything are inappropriate; nevertheless, claims like this are made by some in the precious metals business. Bear in mind, however, that an inflation-adjusted high of the 1980 peak gold price – US$850 – results in a gold price of US$2,080 per ounce today. As such, a price prediction of US$1,800 may not be that outrageous.

In the early 1970s no one would have believed that gold could reach $850, or silver $50. The same holds true for the NASDAQ. When the NASDAQ was 165 in 1980, who would have dreamed that it could reach 5,000?

Although it should be a separate myth, Smith also scoffs at the idea that any reputable money manager would advise that 10% to 20% of an investment portfolio should be allocated to gold bullion. This is likely true, since most money managers today are not old enough to have experienced the last bull market in gold, or the 1964–1982 bear market in equities. Their entire investment experience has been confined to one cycle - the biggest and longest-running equity bull market in history. While many of the world’s wealthiest families do have substantial gold holdings, most US and Canadian portfolios have no allocation to precious metals whatsoever. Many North American confuse gold bullion and mining stocks, and do not appreciate that bullion is an entirely different asset class with vastly different risk and liquidity characteristics.

And yet the majority of money managers claim to provide their clients with balanced, diversified portfolios, even though those portfolios are limited to stocks, bonds and cash. Since there are seven asset classes in total – stocks, bonds, cash, real estate, commodities, precious metals and collectibles – today’s typical investment portfolio is anything but diversified or balanced. Many advisors will be faced with massive law suits when investors suffer losses during this cycle, because they only allocated to declining assets and didn’t provide adequate diversification.

Because there is very little information or methodology available to assist in determining what an appropriate allocation to precious metals should be, in 2005 I commissioned a study by Ibbotson Associates. Ibbotson is recognized as a world leader in asset allocation, and bases their work on Harry Markowitz's mean-variance optimization paradigm - the heart of strategic asset allocation. Because gold’s economic role changed so drastically following US President Richard Nixon’s closing of the gold window in 1971, Ibbotson studied the period from 1970 to 2005. That was as far back as they could go to make meaningful investment comparisons.

Ibbotson reached several conclusions. First, they concluded that precious metals are the most negatively correlated asset class to traditional financial assets and, as a result, they act as a hedge for the entire portfolio. During high inflation periods, precious metals outperformed all asset classes. During periods of stress, they provided returns when they were needed most. During low inflation periods, they provided bond-like returns. Ibbotson found that, based on a strategic asset allocation model, investors could potentially improve reward-to-risk ratios in conservative, moderate and aggressive portfolios with allocations of 7.1%, 12.5% and 15.7% respectively. Their work did not take into account any of the risks posed by rising inflation, rising debt levels, federal budget and current account deficits, rising oil prices, geopolitical tensions or any of the current vulnerabilities and imbalances in the economy.

In addition, studies have been carried out by David Ranson, head of research at Wainwright Economics, with respect to the amount of gold necessary to immunize portfolios during periods of rising inflation. He concluded that, for optimum results, investors need 18% for a bond portfolio, and 47% for an all-equities portfolio.

From a tactical asset allocation point of view, a portfolio’s allocation to bullion should be much higher in today’s economic climate. Tactical allocations should be adjusted to the directional trend of the Dow:gold ratio in order to maximize returns. When the ratio is rising, as it was from 1920-1929, 1945-1965, and 1980-2000, portfolios should be overweight financial assets. When the ratio is falling, as it was from 1929-1945, 1965-1980 and 2000 on, portfolios should be overweight precious metals.

On August 15, 1971 the Dow was 856 while gold was $35 per ounce, for a Dow:gold ratio of 24:1. By January 21, 1980 gold had risen to a peak of $850 per ounce while the Dow stood at 872, for a Dow:gold ratio of 1:1. At this point the cycle changed and the Dow:gold ratio rose until it peaked at 44:1 in 2000. It has been dropping ever since, and now stands at 19:1. Many specialists in cyclical trend analysis believe that, at the end of this cycle, the ratio will again be 1:1.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

The "Money Flow" Myth and the "Liquidity" Trap
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“To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

“Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.”
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Sell Gold in May and walk away - Not This Time
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In the March update, I wrote:

Gold had a false breakout in February. However both gold and silver retested solid support at their 200 DMAs. The Asian gold market has been very strong, partially due to the increasing purchasing power from their strong currency….Last time I remembered having seeing urgency by Asian gold traders to buy was in November of 2005 when gold broke through key resistance of $450 and raced to $730 in six short months.

The important $650 resistance level for gold has now been breached and I don’t think gold will look back. We could reach $720 by end of May, which will spell the start of a new and possibly most spectacular phase for gold to date.

XAU




In March we wrote

The XAU over Gold ratio again tells us the current sentiment for gold stocks is at an extreme low and that we are likely right at the bottom for gold and gold stocks at this time.

Typically, third time is the charm for trying to overcome a resistance. XAU has been trying for the 150 resistance multiple times and we believe this level will be taken out by end of May. The XAU over Gold ratio also showed a rebound, telling us that the bottom for both gold and gold stocks is firmly in place.
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We wrote in March

If gold clears the $650 hurdle this week, I would be very surprised if gold doesn’t try for its all time high of $850 by September. As opposed to last summer, this summer will be anything but dull for the yellow metal investors.

We also wrote last November titled Seasonality Shift

http://www.kitco.com/ind/Lee/nov72006.html

The market has a way of setting investors off balance. If 2007 is the year that gold makes an intermediary top, we suspect the market will spoil those investors that follow conventional seasonality.

And let me finish this update by quoting the November conclusion

Historically, the gold market has followed a strong seasonal cycle. The old adage traders live by is “sell in May and walk away, buy in September and harvest by spring.” The lack of positive gold market action in September has caught many by surprise. Is this the end of the gold run or merely a slight delay before the bull resumes?

As we outlined, the XAU over Gold ratio indicates gold is near the bottom, not the top. Fundamentally and technically, the dollar remains bearish. Moreover, the gold equities simply haven’t exhibited the type of action we call the “maniac blow off”; a select number of juniors remain exceptionally cheap with current metals prices taken into account.

This is not the first time during the bull run that a fall breakout has been delayed. In late 2002 the XAU traded between 60 to 80 from September to late May until it finally broke out in April. When the breakout finally occurred it was astounding. The XAU rose 70% going from 65 to over 110 in 6 short months. If XAU were to follow the same suit this time, we would now expect it to consolidate between 120 and 170, eventually taking out 170 around next April on its way towards 300, again defying those who choose to sell in May, and walk away.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Cutting Through the Bull
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As we've explained many times over the years, one of the best ways to see what's really happening to the stock market is to look at long-term valuation trends. In particular, we can effectively remove the distorting effects of inflation from our interpretation of the stock market's long-term trend by defining a secular bull market as a generational (15-25 year) trend toward higher valuations and defining a secular bear market as a generational trend toward lower valuations. One reason is that lower valuations (lower multiples of earnings, sales, book value and dividends) are invariably assigned to stocks during periods when a large chunk of corporate profit growth is perceived by the investment community to be the result of inflation.

With the above definitions of the secular trend in hand, a look at what has happened to the US stock market's average valuation over the past 80 years will reveal that: a secular bear market commenced in 1929; a secular bull market commenced in the mid-1940s; a secular bear market commenced in the mid-1960s; a secular bull market commenced in the early-1980s; and a secular bear market commenced during 1999-2001.

Interestingly, but not surprisingly for anyone who understands the nature of gold, when the US stock market's performance is measured in gold terms its long-term trends roughly line-up with the aforementioned long-term valuation trends. Therefore, secular trends in the US stock market can also be seen by looking at long-term charts of the Dow/gold ratio.
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It recently occurred to us, however, that an important long-term chart that we have never looked at in the TSI commentaries is the Dow Industrials Index adjusted for changes in the total supply of money. In other words, it occurred to us that we've shown surrogates for the inflation-adjusted Dow on many occasions but have never shown the actual inflation-adjusted Dow.
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Below is a chart of the Dow/M3 ratio (the Dow Industrials Index divided by the total US money supply). Unfortunately, we don't have M3 data prior to 1959, but the data we do have is enough to tell us that long-term trends in the inflation-adjusted Dow mesh quite well with the valuation and Dow/gold trends discussed above.

The bottom line is that whichever way we look at it we see that US equities are presently about 7 years into a secular bear market.


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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Bullion Vault: Dow/Gold Ratio: Where Next?
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How to choose the best bolt-hole for your savings and wealth? Clearly real estate's doomed, for the short to mid-term at least. Government bond yields are now so far underwater, you'd be killed by the bends if they tried to come up for air.

That leaves commodities and stocks, the classic refuges for inflationary crises. And one way of judging the Dow – free from all Dollar distortions – is to measure the index in terms of gold ounces.



Dividing the Dow Jones Industrial Average by the price of gold gives you a rough idea – over time – of where the real value might lie. It shows how many ounces of gold you would need to buy one unit of Dow stocks.

Hence gold was a raging sell (in hindsight at least) when the Dow/Gold ratio touched 1.0 at the start of the 1980s. Stocks scarcely looked back for the next 20 years. But by the end of the '90s, the real value had shifted again. And gold surged as the Dow sank after the Tech Stock Crash of 2000.

That slump in stock prices compared with Gold pushed the Dow/Gold ratio down from its all-time top above 42.2 to just 12.6 in March of this year.

That's pretty much exactly the Dow/Gold average of the last eighty years. So which way will the ratio go now?

The Fed's new "reflationary melt-up" is clearly designed to keep stock prices buoyant. But it's only adding to the Case for Gold, too. "I would be very surprised if the Dow Jones Industrials/Gold Ratio didn't decline to between 5 and 10 within the next three years," said Marc Faber of the Gloom, Boom & Doom Report recently.

If that call proves right, it might come thanks to Gold Prices doubling, or stock prices halving, or more likely some combination of both. But while the three peaks to date – of Aug. 1929, Jan. '66 and then late '99 – took the Dow/Gold's top higher, the floor only held steady, down there at two ounces of gold and below.

And the last slump – during the inflationary 1960s and stagflationary '70s – took a full 14 years to work itself out. So far in this bear market for the Dow/Gold ratio, we're nine years through to date.

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I think this is important to understand. Given the Fed's attempt to reflate the economy and all asset prices through overly accommodative monetary policy, the Dow Jones Industrial Average may very well go up. The Dow going up is not at odds with the price of gold going up. What we as Joe Six-Packs want to know is which is going to go up faster, thereby increasing (or at least maintaining) our purchasing power better.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Stockhouse: The stock market’s secular trend
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There's a big difference between a stock market that's rising in real (purchasing power) terms and one that's only rising due to currency depreciation. The reason is that a smart person invests to obtain more purchasing power, not more money.
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Further to the above, the stock market's secular trend can't reasonably be determined by referring to nominal price changes. In particular, just because the stock market happens to be making new highs in nominal price terms doesn't mean that a secular bull market is in progress.
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As discussed in many previous commentaries, the best way to “see” the U.S. stock market's secular trend is to look at a long-term chart of either the market's valuation (price/earnings ratio) or the market's performance relative to gold. As illustrated by the following chart-based comparison of, from top to bottom, the S&P500 Index, the earnings of the S&P500 Index, the S&P500's price/peak-earnings ratio, and the Dow/Gold ratio, over the past 80 years these alternative ways of ascertaining the stock market's real long-term trend have always yielded the same result.

[Steve Saville's charts can be found here.]

The reason why the stock market's REAL long-term trend is so clearly defined by long-term trends in valuation and performance relative to gold is that investors, as a group, will invariably pay less for earnings that are perceived to be artificially boosted by inflation than for earnings that are perceived to be the result of real (sustainable) growth. Notice, for example, that the S&P500's earnings grew just as rapidly during the secular bear market of 1966-1982 as during the secular bull markets of 1942-1966 and 1982-2000. The difference is that during 1966-1982 there was increasing recognition of an inflation problem, leading to the compression of price/earnings multiples and dramatic weakness in the stock market relative to gold.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

FT Alphaville: The gold-to-oil ratio

It may be hard to imagine, but there is one market position that has significantly outperformed most major commodity indices of late - the gold-to-oil ratio, which is a position that involves selling oil and buying gold.

In fact, as Petromatrix’s Olivier Jakob points out, the ratio has reached its highest level since 1999 - when WTI was $10 per barrel. And with many analysts foreseeing further strength in gold in the near-term, the odds the ratio will continue rising look good.
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_________________
Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Richard Russell makes the point that asset allocation is more important than stock selection.
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321Gold.com: Ignored, Dismissed, Disliked
by Richard Russell
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In traditional common stock bull markets, we old-timers always watched the action of the low-priced "cats-and dogs" (there used to be a "low-priced stock average"). Somewhere towards the latter part of a bull market, the cats-and-dogs would make their moves. When the low-priced stocks perked up, that was usually a sign that the public was entering the bull market. Most of the veteran analysts would follow the low-priced index, and when the "dogs" started to move, we'd load up on them and ride them to the end of a bull market. Often, fortunes were made when the cats-and-dogs started to surge. At such times, many low-priced stocks would double and triple in price within a year or two. We bought them willy-nilly, who cared about the names, if they were selling below 3 or 4 dollars a share, that was enough, we just piled in and bought them.

I've wanted to apply the same logic and technique to the gold bull market. Up to now, interest in the gold stocks has largely been confined to the better-known mining companies. But recently, an exchange traded fund (ETF) has been made available, its symbol is GDXJ. I equate GDXJ to the former "low-priced stock Index" of "cheapie" stocks that we monitored in older traditional bull markets.

The recent action and relative strength of GDXJ has been interesting. The first chart below compares GDXJ with GDX. GDX is the ETF which includes the larger and better known gold mining stocks. Here we see that GDXJ is out-performing GDX, which means that the smaller and more speculative gold miners are now out-performing the larger, better known gold mining stocks. Thus, speculation in gold mining stocks is beginning to increase.



The next chart [below] compares GDXJ with actual gold. This chart tells us that during recent months, the "cats-and-dogs" of the gold mining world are acting stronger than gold itself. What interests me here is that based on the relative strength action of GDXJ, I'm assuming that interest in gold is heating up. One reason for this is that as the price of gold rises, large miners will want to increase their gold reserves, often by buying up smaller mining stocks (which have proven gold reserves but who lack the money to recover their reserves).

Rising interest in gold is coming at a surprising time. With the Greek problem in the news and with talk of a crippling euro and thus a stronger dollar, gold should be weakening (the stronger dollar would ordinarily be placing pressure on gold). If so, then why is GDXJ picking up in relative strength? Is something else going on that we don't know about?


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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

US Civil Flags: The Dow/Gold Ratio to drop to 7 this year NIA
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The number NIA cares most about is how the Dow Jones performs in terms of gold or the Dow/Gold ratio.
One of our top ten predictions for 2010 that we announced on December 21st, was that we would see a sharp decline in the Dow/Gold ratio from 9.3 to below 7.
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After the inflationary crisis of the 1970s, the Dow/Gold ratio reached a low in 1980 of 1. NIA believes the inflationary depression that we are currently in will not be over until the Dow/Gold ratio reaches a bottom of 1. This means we expect to see another 88% decline in the price of stocks in terms of gold.
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The second most important number NIA cares about is the median U.S. home price/silver ratio. The national median home price is currently $166,100 or 9,400 ounces of silver.

When silver reached its all time high in January of 1980 of $49.45 per ounce, the median U.S. home price at the time was $62,900 or 1,272 ounces of silver. We expect the median U.S. home price/silver ratio to return to that level by the time this inflationary depression is over. This means we expect to see another 86% decline in the price of Real Estate in terms of silver.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.