Will A Gold Price Uptick Indicate A Large Stock Market Downdraft Has Arrived? – Seeking Alpha

I started trading stocks in 1986, and can vividly remember the first time I heard the idea of timing U.S. stock market gyrations by using the Dow to Gold ratio in the summer of 1987. Some trader was being interviewed on the Financial News Network (predecessor to CNBC) explaining how changes in the U.S. Dollar price of gold vs. the Dow Jones Industrial Average could help put investors on the correct side of a market call. I was fascinated that two seemingly unrelated markets could be referenced against the other and deliver any kind of meaningful analysis.

Sure enough, the overall level of the Dow vs. gold prices, and shorter-term movements in both can signal truly profitable trading decisions. I remember telling everyone that would listen during the late 1990s, a sky high, all-time 40 level in the ratio would likely mean owning gold and shunning stocks would be a smart investment proposition the next decade or two. I forecasted such in the last few issues of my Maverick Investor newsletter during 1997.

I quit writing about the equity markets as a profession in late 1997 because it was clear the Technology/Internet boom was getting out of control in terms of valuations and confidence. Gold, on the other hand, had dribbled lower since 1980, from better than $800 an ounce to under $300 between 1997 and 2001, some 20 years later. When my family asked what I wanted for Christmas during those years I told them gold coins! I think there were 5 or 10 of us left in the nation that loudly advocated owning oversized gold positions in public forums and situations. Not many people took me seriously. Gold was dead, a relic of the past, declared Wall Street and the mainstream press.

Dow to Gold ratio history

You can review the Dow to Gold ratio the last 100 years pictured below, with recessions marked in grey, courtesy of the Macrotrends website. Today’s near 18 number is quite high, a good distance above the long-term averages in the 9-10 range, well above the 1 to 1 low ratio of 1980, while nowhere near the 40+ high numbers of the late 1990s. You can see how the stock market and gold direction often diverge. This low or even negative correlation is the logic used by old-timers like myself to hold gold. Gold does a wonderful job of hedging inflation over time, retaining or increasing purchasing power during recessions, gaining during periods of aggressive money printing and cushioning the blow to portfolios when a bear market hits equities.

Of course, the gold price of $1230 in 2017 has handily bested the total return from stocks since the late 1990s. Burying this arcane relic of past civilizations in your backyard actually earned more in profits than the S&P 500 index or Dow Industrials. Measuring from the first trading day in the year 2000, gold has risen +330% in dollar terms. This gain ran circles around the S&P 500 total return (including dividends) of around +140% and the Dow Industrial equivalent gain of +180%, before holding or trading expenses are considered. Don’t tell anybody, but Warren Buffett’s Berkshire Hathaway (BRK.A) (NYSE:BRK.B) has only kept pace with the rise in gold, profiting by +390% the last 17 years. In other words, the world’s greatest stock investor and business mind alive today struggled to add meaningful value vs. gold buried in your backyard at the turn of the century! That’s what the Dow to Gold ratio predicted would happen at a record 40 to 1 multiple in the late 1990s.

Short-term signals from the ratio

While no indicator works in every instance, plenty of buy and sell signals for the general U.S. stock market have been led by movements in the Dow to Gold ratio. For purposes of this article, let’s review a 2-year chart of the ratio vs. the Dow’s underlying price changes. I have circled in red the beginnings of big market sell-offs during 2015 and 2016 that were predated by a bump higher in the gold price and a turn lower in the Dow to Gold ratio underneath the 50-day moving average. In contrast to these successes, you can see how 2017 moves below the same moving average had no predictive value. However, each passing day is a day closer to the next equity market correction, and plenty of technical trading evidence warning of an eventual decline has been accumulating all year. You can review my market correction story from June here. Most of the reasons for a market pullback still exist today.

I suspect a drop in the next week or two below the 50-day average, at 17.00 currently, could be an important development at this juncture of the fading stock market advance. Seasonally speaking, summer tops followed by declines in the August-October period are common on Wall Street. We can debate whether a normal 10% correction in the S&P 500 and Dow is next or something worse. Either way, a drop in the Dow to Gold ratio may occur first. Intelligent investors can watch this indicator for the exact timing of cutting back U.S. equity exposure in late summer.

Reasons for optimism about the intermediate-term prospects for gold

Hebba Investments on Seeking Alpha does a nice job of following the precious metals market. He posted an excellent article last week on the position changes by traders and speculators in the gold futures market. In summary, the net long/short positioning of players in the gold exchange pits is more typical of a bottom today than a top. From Hebba’s July 10th article,

The latest Commitment of Traders report showed a fourth straight week of speculative long selling in gold as gold dropped on the week. Not only were speculative longs closing out positions, speculative shorts were jumping into the action as they increased their own positions by over 20,000 contracts on the week – the largest speculative short increase since November 2015. At current levels, the gold market now has one of the lowest levels of bullishness on the year, and we think is ripe for a bit of a relief rally…

For contrarian thinkers, proven historically, there now exists a large pool of potential buyers in the gold market given a rising trend. Plenty of short covering and new buying could enter the futures market, helping support prices either in a relief rally or the beginnings of a new bull market for hard money.

A second reason to believe gold is set to run higher, an advancing trend in crude oil quotes and overall inflation on the planet could reappear soon. I wrote an article in June about the odds we are in the early stages of an unexpected jump in oil inflation. The #1 black swan risk for U.S. stock prices currently is a strong crude oil rise, in my opinion. Since gold and oil are often tied at the hip for performance, an abrupt drop in the Dow to Gold ratio may soon take place if oil prices begin to climb. A classic setup of rising inflation and falling stock prices could be the Wall Street macroeconomic story during the second half of 2017. I mentioned the long oil vs. short financials pair trade idea in my last article.

Final Thoughts

A break below 17 in the Dow to Gold ratio could prove an early warning of trouble for the overall U.S. stock market. A minor 4% net change in the components should not be ignored by investors paying attention. Either a 4% rise in gold with a flat Dow, a flat gold price with a -4% decline in the Dow or a 2% increase in gold vs. a -2% drop in the Dow could highlight serious selling in equities lies dead ahead.

Gold speculators and traders may jump on board the buy side quickly with the right world events and/or geopolitical risks exploding into the news headlines one morning. Gold and crude oil like to move in tandem, and oil looks set to zig-zag higher the remainder of 2017.

My opinion, based on three decades of investing and trading, is the Dow to Gold ratio is set to contract substantially in coming years. The next big move in the ratio may include a rise in gold prices above $1500 to as high as $2000 an ounce while the Dow Industrial Average languishes or falls in price. A regular ratio under 10 is not a far-fetched idea in 3-5 years. If so, gold will enter another period of outperformance, reversing its underperformance trend vs. equities since 2011.

If you want to create your own long/short position play on a possible decline in the Dow to Gold ratio back toward a regular long-term reading under 10, it is much easier to accomplish with ETFs today than a few decades ago. Low cost gold products to consider for long ownership are the SPDR Gold Trust ETF (GLD), iShares Gold Trust ETF (IAU), Sprott Physical Gold Trust ETF (PHYS) and the 2x leverage ProShares Ultra Gold ETF (UGL).

You can short the Dow and S&P 500 with low expense products SPDR Dow Jones Industrial Average ETF (DIA), Vanguard S&P 500 ETF (VOO) and SPDR S&P 500 Trust ETF (SPY). Other U.S. market funds to consider in a long gold, short stock portfolio position (or vice versa if you are bullish on the Dow to Gold ratio) are the Vanguard Total Stock Market ETF (VTI) and Schwab U.S. Broad Market ETF (SCHB).

There are numerous ways to use the Dow to Gold ratio in your portfolio forecasting and planning. Maybe you can invent some new ones. Let your imagination run. As always, continue researching this idea further before making any trade, and don’t be afraid to speak to a registered financial adviser if you have questions or want another opinion.

Disclosure: I am/we are long GLD, UGL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.