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What is the Dow to Gold Ratio?

What is the Dow to Gold Ratio?

           
         Key Takeaways

  • The Dow to Gold Ratio compares the strength of the stock market to gold.

  • It's calculated by dividing the Dow Jones Industrial Average by the current price
    of an ounce of gold.

  • A high ratio suggests limited upside for equities, while a low ratio suggests it may be a
    good time to buy.

Investors are always looking for new metrics to provide insights on which assets to buy. This article explores the Dow to Gold ratio, a helpful indicator with a proven track record for helping people allocate capital efficiently.

What is the Dow to Gold Ratio, and how is it calculated?

The Dow to Gold Ratio measures the relative strength of the stock market versus gold. It’s a tool investors use to decide if either asset class represents good value for money.

The Dow to Gold Ratio is calculated by taking the Dow Jones Industrial Average (DIJA) and dividing it by the current price of an ounce of gold. For example, if the Dow is 33,400 and an ounce of gold is $1,500, the Dow to gold ratio is 22.27.

Note that the Dow to Gold Ratio is currency sensitive. You will get a different result if you divide by the gold price in pounds or yen.

Why is the Dow to Gold Ratio significant, and what can it tell us about the stock market and gold prices?

The Dow to Gold Ratio is significant because it reveals information about the relative price of assets. Gold or U.S. stocks can remain overvalued compared to each other short term, but they will eventually revert to the mean. A high stock price in terms of gold suggests limited upside for equities, while a lower price suggests it might be time to buy.

Historically, gold and stock prices moved in opposite directions. When the ratio was high, stocks crashed. When it was low, they boomed.

What are some historical trends in the Dow to Gold Ratio, and what insights can we draw from them?

The Dow to Gold Ratio varies significantly over time. When it rises, it means the market is bullish. When it falls, investors feel bearish.

The Dow to Gold ratio was low for most of the 1970s. During stagflation, investors sold stocks because of limited growth prospects and bought gold because of high inflation.

The metric fell to its lowest point in the 1980 stock market crash. Back then, the value was just 1, meaning you could buy the whole market with just one ounce of gold.

From there, it saw a sustained recovery. In 2000, the ratio peaked at over 40 at the height of the Dotcom bubble as investors imagined unlimited profits from new internet-based companies.

After the financial crisis of 2008, the Dow to Gold ratio fell again. Investors fled blue-chip U.S. stocks and piled into safe-haven assets like gold.

For most of the post-war era, the Dow to Gold ratio has been high, averaging around 10. However, during WWII and the pre-war era, the range oscillated between 2.5 and 5 because there were hard limits on cheap credit expansion.

How can investors use the Dow to Gold Ratio to inform their investment decisions?

Intelligent investors use the Dow to Gold ratio to inform long-term asset allocation decisions. Value-oriented individuals may use the metric to determine if gold or equities are underpriced and allocate capital accordingly.

For instance, suppose an investor observes that stocks are reaching all-time highs in terms of gold. If so, equities might not have much further to rise and will soon fall.

Alternatively, imagine the Dow to Gold ratio is low. That would mean that enquities are historically cheap, and now might be a good time to buy.

What are the limitations of the Dow to Gold Ratio, and how should investors use it in conjunction with other metrics and analyses?

The Dow to Gold ratio, however, isn’t perfect. It can’t tell you whether stocks are intrinsically cheap, only that they are inexpensive in terms of gold.

That’s because the gold price could fall for reasons unrelated to equities. For instance, there could be an increase in supply or a fall in demand from central banks. People might also switch from gold to alternative safe assets, like silver, government bonds, or housing.

Therefore, the Dow to Gold ratio should only be one metric investors use to assess the relative value of stocks. They should also consider others, including the price-to-earnings (P/E) ratio, the price of stocks relative to bonds, and historical returns. These provide a more direct way to determine the price of stocks.


Article Last Updated: Tuesday, March 28, 2023