Dow / Gold Ratio Update

Back in our previous series of posts entitled Currency, Money and the Economy, we used a ratio to provide a measure of the value of paper assets versus real assets (refer to the post Identifying the Trend, 10/13/2009). We simply divided the value of the Dow (paper) by the price of gold (real). The ratio represents the public’s belief in holding paper assets. The higher the number, the more the public will want to own paper assets. The lower the number, the more the public will want to own real assets. The number also peaks and valleys at critical junctures in the history of the American economy (the Great Depression, the 1970’s, and the dot com boom and bust).

Below is a 3-year chart showing the Dow / gold ratio (click to enlarge). As you can see, the ratio was at 20 when it began its fall when the housing market went bust. As people fled paper for real assets, the ratio dropped all the way down to 7 before the market bottomed out in March 2009. Since then, the ratio has stabilized between 8 and 10, the most recent drop corresponding to the European debt crisis. The ratio is now moving back up towards 9 as the markets stabilize once again on earnings reports. Two horizontal lines, drawn at 7 and 10, show how the ratio has stabilized between this range. Governments around the world have taken enough action during this time to stabilize the ratio and keep the public’s faith in paper assets.

However, as the Greek economic crisis demonstrated, governments piling up too much debt can send people to sell paper assets in a heartbeat, as we saw that ratio drop from 10 to 8 (20%) in a matter of only three months. And as the United States continues to print more and more currency to get itself out of this current economic funk, they continue to sow seeds for the next economic crisis. History has shown us that once the Dow / gold ratio peaks (42 in 2000), it will continue to fall until the ratio drops to 2 or less. So while the ratio appears to have stabilized for now, the amount of debt the United States has racked up will only serve to push the ratio lower down the road.