Gold Compared to the General Stock Market

Comparing gold to the general stock market is very useful as both asset classes are often viewed as alternatives. Both are impacted by inflation, so their ratio should not be affected by the latter. Moreover, the ratio already proved to be useful on an approximate basis – the last major top and major bottom were somewhat in tune with the previous extremes. Consequently, this tool should be very useful in estimating how high gold can rally before THE top is in.

Let’s take a look at the Dow to gold ratio charts below. The price of gold is in the denominator of the Dow to gold ratio, so in order to predict the top in gold, we’re going to predict the bottom in the ratio.

The ratio is a great long-term tool, because it clearly shows what asset class dominates the market and in what part of the bull or bear market gold and stocks currently are. The major top in the ratio was seen about 20 years ago and it has declined to much lower levels since that time. Right now, we are witnessing a corrective upswing that those who are short- or medium-term oriented view as a big rally. Indeed, even from the medium-term point of view, the rally is sizable, but we should keep in mind that something very similar took place in the mid-70s and it was only a corrective upswing, not the beginning of a new decade-long rally. This time, the rally in the ratio is bigger than it was in the 70s, but please note that the entire history of the chart is characterized by an increase in volatility in both directions, so a bigger corrective upswing this time is not something odd. Conversely, it seems to be in tune with the above tendency.

So, given the increased volatility in both directions, it seems that the corrections should be characterized by bigger volatility than the previous ones as well. The upswing in the ratio that started in 2011 is bigger than one that we saw in the mid-70s, but this seems rather natural in light of the overall increase in the volatility. Since the extent to which the current upswing is bigger than the mid-70s correction is rather natural, it doesn’t seem that the move higher is anything more than just a correction. Therefore, as far as big, long-term moves are concerned, it seems that the ratio is still not done declining. In consequence, gold is most likely not done rallying, even though it’s been moving lower for about 7 years now.

But how low can the ratio go? There are several ways in which we can determine the likely target and they are all based on the fact that history tends to repeat itself. The question is in what way it will repeat.

The ratio could simply move to one of the previous bottoms. The previous bottoms are at 1.94 and 1.29. Both could serve as the key support and the same goes for any level between them. The average is 1.615. Overall, we can assume that the ratio is likely to move below 2 before the final bottom in it and the final top in gold are seen.

Now, since the moves in both directions are getting wider, it seems much too conservative to assume that the ratio will move only to the upper of the above targets – the 1.94 level. Actually, even 1.29 is reasonably conservative as it only assumes a move to the previous extreme, not below it, which seems likely if the widening continues.

What seems most likely, however, is that the widening of extremes will continue. In this case, we can expect gold to move to the declining very long-term support line, just as it rallied all the way to the rising very long-term resistance line almost 20 years ago. Consequently, the question becomes when will the ratio cross the line and at what level. While this is not our official prediction, for the sake of this article, let’s assume that gold will top in 5 years. The line is not visible on the above chart, but knowing the price and date of the previous extremes we can calculate the correct amount. In March 2018 it’s 0.93, and in March 2023, it will be at 0.89. All in all, it’s approximately at 0.9.

The above is very important from the psychological point of view. With the ratio at 1, gold’s price will be equal to the value of the Dow Jones Industrial Average and everyone and their brother will notice that. No financial journalist will allow this fact to remain unnoticed. There will be theories about a new paradigm in which all that’s not from or about precious metals is trash and any other asset class is useless. This should trigger very emotional buying of gold by the general public, which would likely result in the final parabolic blow-off in gold prices. Then, 10% - 11% above the value of the Dow Jones Industrial Average, gold could form its multi-year top.

Will the ratio really decline as low? It’s impossible to know for sure, but it seems very likely that we’ll see the Dow to gold ratio below 2 in the coming years and values below 1 could really be seen. OK, with established targets for the ratio, the question becomes where the Dow will be during gold’s top.

At the moment of writing these words, Dow is very close to the $25,000 mark. Given the above estimates for the Dow to gold ratio, this implies gold topping at least at $12,500 and possibly above $25,000 – even at $27,500 or so.

These levels could be achieved, but it doesn’t seem all that likely. In the past, the general stock market declined along with the ratio. In the case of the 1930s, it’s obvious as the price of gold was fixed – the ratio’s movement was based solely on the stock market’s slide.

So, how low will the stock market decline? To be clear – the Dow doesn’t have to decline, but based on the above long-term cycles in the Dow to gold ratio, it’s likely to. The big Dow decline that preceded the 1980 bottom in the ratio was smaller than the one that preceded the 1933 bottom, so if this trend continues the upcoming corrective downswing could be lower as well. The above assumption seems to have some fundamental backing, as the tendency now is to throw money at the declining stock market and hope for the best (remember Bernanke in 2008?). With money being pumped into the stock market during the next big downswing, the size of the decline may indeed be limited and, for the same reason, the final topping price for gold could be higher.

Still, if history is to repeat itself to at least some extent, the Dow should decline, and the decline should not be minor. About 50 years ago, the Dow topped at about 7,500 and started a decline that ended in June 1982 below 2,100. The top in gold and the bottom in the Dow to gold ratio, however, formed earlier, with the Dow at about 2,800. This means that the price of the Dow was cut by over 62% (by the way, that’s remarkably close to the classic Fibonacci retracement of 61.8%, isn’t it?). The decline of the 1930s cut Dow by more than 85%, so it was even more extreme. But can we really expect Dow to decline by as much in light of the money-printing policy? Not necessarily, but since the 80s decline was 23% smaller than the one from the 30s, then maybe we’ll see a similar decrease also this time. In this case, we would be looking at a decline of about 39%. This is remarkably close to another classic Fibonacci retracement – 38.2%, so maybe there’s something to this very rough approximation.

At the moment of writing these words, we can’t know if a long-term top in the Dow is already in, but let’s assume that it is. If not, then it would imply a higher target for the final low and thus a bigger gold price target for the final top.

Cutting 38.2% from 25,000 leaves us with 15,450. If the decline is even bigger huge (but still smaller than the one from the 80s), we might see a 50% decline from the top. That would give us 12,500 as the target.

The methodology used above is more of an educated guess than a detailed multi-factor-based estimation, but since we’re using it to estimate ballpark figures (in order to confirm or invalidate more precise targets based on other techniques), it seems useful.

So, the lowest target for gold that we can obtain based on the above is a decline to 12,500 in the Dow along with a move to only 2 in the Dow to gold ratio. This means that gold is likely to rally at least to $6,250. We have already discussed the optimistic (for gold) target – 25,000 in the Dow (perhaps a correction to the current levels after a rally to 30,000 instead of a bigger decline?) accompanied by a Dow to gold ratio below 1 implies gold north of $25,000.

A more moderate target that’s based on the averages of the predictions is based on 15,450 in the Dow along with 1.29 as the target for the Dow to gold ratio. The above implies gold at about $12,000.

That’s also relatively close to $12,500, which is a geometric average of the two remaining targets based on the extreme predictions ($6,250 and $25,000). We’re using the geometric average instead of the arithmetic one as that’s more useful when multiplications are involved in the calculations and that’s the case here.

Summing up, the overall target price range for gold based on the Dow to gold ratio analysis is $6,250 - $25,000, and the most probable target for gold is $12,000. Of course, it will not be seen overnight and most likely we won’t see gold at those levels by next week either. The above prices are something that might be reached in the next several (4-7) years, but we don’t want to get into the details regarding timing in this essay as don’t want to turn it into a book. We’ll get back to this issue in future analyses.