Long Lost Lovers

Whoa! Another severe drop in the markets yesterday. The Dow ended the session down 4.6%, plunging through the 11,000-point mark along the way. The S&P 500 and the Nasdaq chartered a similar course, off 4.4 and 4.2% respectively. Both have lost more than 10% for the year. The Dow, too, has erased all gains earned over the past twelve months.

What happened to the recovery? That word was all the rage until a few weeks back. “Welcome to the Recovery,” wrote Treasury Secretary Timothy Geithner a year ago, in an op-ed piece in the New York Times. President Obama and his #2, Joe Biden, went so far as to call it the “Summer of Recovery.”

Well, where is it? And, more importantly, why do these men still have jobs? Why are they not selling fridge magnets from a tin tray on street corner somewhere? More on that tomorrow…

In yesterday’s reckoning, we promised a wee discussion on gold. But, with all our ranting and raving about the inexorable decline of the Anglo-Saxon Empire and the not entirely unrelated riots in London, we ran out of time. Today, we pick up where we left off.

Gold scooted past $1,800 per ounce yesterday, before cooling a little to end the session around $1,790. That brings The Midas metal’s gains for the past twelve months to around 50%. Not too shabby. Understandably, therefore, investors are wondering whether it too late to hitch their wagon to the gold train? Have they missed the action? Is the golden bull market, now a decade old, finally over?

As usual, your editor has no idea. And, as usual, he will offer one anyway. But before having a look at the year ahead of us, let us first read the prologue.

At the 2010 Agora Financial Investment Symposium in Vancouver, back when gold was on offer for the bargain price of just $1,200 per ounce, we made a prediction. It was prompted by the previous evening’s Whisky Bar discussion. Members of the panel were asked to guess where gold and stocks would be in a year’s time (today). Exact estimates varied, but the general consensus was that gold would be higher and stocks lower. They were half right.

Not a member of the panel himself, your editor published his own guess in the following morning’s issue of The Daily Reckoning. We had the same idea, but our method was a little different. Take a look:

“[I]nstead of measuring the [Dow] index in points and the metal in dollars, we’ll do away with floating abstractions and simply measure the index in metal.

“Historically, the peak of a gold bull market/stock bear market occurs when you can pick up the 30 bluest stocks for about one, maybe two, ounces of gold. The Dow/Gold ratio, at that point in time, is said to be around 1:1 to 2:1. During the furor of tech. mania in the late ’90s, early ’00s, when the Midas metal was scoffed at in polite company, that ratio reached 45:1. In other words, it would take you 2.8 POUNDS of Mother Nature’s money to buy the Dow.

“During the past decade, as stocks stagnated and gold rallied fourfold, that ratio has slipped dramatically. Today, it takes about 8.6 ounces of gold to buy the Dow. Our bet, for what it’s worth, is that this trend continues for a while yet. Next year, we’re probably looking at a Dow/Gold ratio of about 6:1…and not because the Dow goes to 60,000.”

This morning, with gold at $1,780 and the Dow at 10,719, we hit the mark: the Dow/Gold ratio is, exactly, 6.02:1. So it took 55 weeks for our one-year prediction to come to pass. That’s close enough for us.

Of course, past performance is not necessarily indicative of future ability. As the old saw goes, even a broken clock is right twice a day. Nevertheless, we’ll stick with the thesis that led us to last year’s conclusion…and use it to inspire this year’s guess. The rational behind it is simple: A bet on gold is a bet against the Bernankes, Obamas and Geithners of the world. It is a statement that says “I don’t believe you know what you are doing, sir.” With that in mind, we reckon the Dow/Gold ratio will contract further still, meaning it will take fewer ounces to purchase the 30 stock index a year from now. How many, exactly? Good question…

All sorts of things could happen over the next twelve months, events that could jolt markets hither and gold thither. For one, QE3 is definitely on the cards. The Fed Head said so himself. And Wall Street is calling for it too. Then there’s China’s “nuclear option” in the bond market…the fracturing of the eurozone…the Arab Spring across North Africa and the Middle East…and plenty more the Gods have in store that is beyond our earthly imagination.

Still, it’s no fun if you don’t have a little “skin in the game.” So we’ll tempt fate and take a shot. We already reckon the general trajectory will be the same. Now let’s go out on a limb and suppose that market uncertainty intensifies and that the collapse of the western powers accelerates. And let’s take Bernanke at his word and assume he cranks his printing presses into overdrive.
Let’s say, a year from now, we’re looking at a Dow/Gold ratio of between 3 and 3.5 to 1. And if we’re wrong…well, give it another year. Eventually, these long lost lovers will meet once more.

But where does that leave the terms of the relationship, you ask, the values of the antecedent and the consequent?

How the Heck should we know? Remember, we’re just a broken clock, hoping to be accidently correct twice. You’re on your own from here.


Joel Bowman,
for The Daily Reckoning