THE DOW/GOLD RATIO PDF/Dow Gold Ratio.pdf · chart of the Dow/Gold ratio, which is simply the quotient of the Dow Jones Industrial Average divided by the gold price in US Dollars

On the Cusp Again:

THE DOW/GOLD RATIODecember 2000

GOLDEN SEXTANT ADVISORS LLC

GOLDEN SEXTANT ADVISORSDECEMBER 2000

INTRODUCTION

• The three great bull markets of the Twentieth Century are dramatically reflected in a chart of the Dow/Gold ratio, which is simply the quotient of the Dow Jones Industrial Average divided by the gold price in US Dollars. It is basically the price of the leading index of paper claims on productive assets, divided by the dollar price of an ounce of gold.

– When the ratio is high, as it is in a boom, equities are expensive and gold is cheap.– When the ratio is low, as it is in a bust, equities are cheap and gold is dear.

• Today, the Dow/Gold ratio is at its highest level ever. We believe this signifies the financial world is on the cusp of a huge inflection point, similar to that of the two prior peaks.

– Just as at those prior peaks, financial assets are grossly overvalued, and gold is grossly undervalued.

– Just as those prior valuation extremes resolved themselves through dramatic reversals in both the numerator and the denominator of the Dow/Gold ratio, so will today’s, and soon.


INTRODUCTION

Dow/Gold Ratio: 1915 - 2000

At about 40, the Dow/Gold ratio is at a record high:

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

1915 1925 1935 1945 1955 1965 1975 1985 1995 2005

Dow

/Gol

d Ra

tio

1928: 14.51

1965: 27.30

1999: 39.61

1932: 2.90

1920: 3.48 1980:

1.65


INTRODUCTION

• The key to understanding the Dow/Gold ratio and what it portends lies in isolating the principal factors that affect the numerator (equity prices) and the denominator (the price of gold).

– At every peak, we find the same phenomena:

• Overvaluation of equities• Over-ownership of equities• Excessive liquidity• Excessive credit

– At every trough, we find their opposites.

– And at each extreme, we find a background of breakdown in the global monetary system:

• Collapse of gold exchange standard (1929 - 1934)• Collapse of Bretton Woods standard (1961 - 1971)• Collapse of floating rate standard (pending)

• Today, gold is dead. In 1980, equities were dead. We know how this chapter ends.


THE NUMERATOR

5

10

15

20

25

30

35

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

S&P

500

Pric

e/Ea

rnin

gs R

atio

1917: 5.2

1933: 32.3

1999: 33.4

1904: 17.4

1979: 7.4 1948:

6.6

1961: 22.4

AVG = 14.8

Price/Earnings Ratio: S&P 500

By every rational measure, equity values are off the charts, exceeding their 1929 and 1966 highs. Here are just a few examples.

P/E ratios are at an all-time high.

Price to Book Ratio: S&P 500

1.0

2.0

3.0

4.0

5.0

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Pric

e/Bo

ok V

alue

So are Price to Book Ratios.


THE NUMERATOR

It’s been so good for so long, “Everybody’s in.”

Public participation in the stock market today dwarfs prior levels.

Relative to GDP, the aggregate capitalization of the stock market is at an all-time high

Aggregate Market Capitalization/GDP

Percent Household Participation in US Equities

20%

40%

60%

80%

100%

120%

140%

160%

180%

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Bill

ions

1999: 171%

1965: 75%

1930: 76%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Bill

ions

1968: 38%


THE NUMERATORCumulative Growth: M3 and the Monetary Base

A peak in the Dow/Gold Ratio is at heart a monetary phenomenon. The fuel for the imbalance is always the same: excessive liquidity and excessive credit.

100%

300%

500%

700%

900%

1100%

1300%

1500%

1700%

1900%

2100%

1960 1970 1980 1990 2000

Cum

ulat

ive

Rate

of G

row

th

M3

MONETARY BASE

Since 1960, the aggregates known as M3 and the Monetary Base have increased by over 2000% and 1300%, respectively.

Household Debt as a Percentage of GDP

30%

40%

50%

60%

70%

1960 1965 1970 1975 1980 1985 1990 1995 2000

Hous

ehol

d De

bt/G

DP

During the same period, Household Debt as a percentage of GDP has grown by more than half to over 65%.


THE NUMERATOR

1.25

1.50

1.75

2.00

2.25

2.50

2.75

1920 1930 1940 1950 1960 1970 1980 1990 2000

Tota

l Dom

estic

Deb

t/GDP

TOTAL DEBT/ GDP

SOURCE: CITADEL RESEARCH & ANALYTICS

Total Debt (All Sectors)/GDP

Despite the fanfare associated with the recent paydown of the long bond, the United States economy is saturated with debt.

Total debt as a percentage of GDP is at record levels.

0%

50%

100%

150%

200%

250%

300%

350%

12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00

MARGIN DEBT

NYSE MARKET CAP C

umul

ativ

e Ra

te o

f Gro

wth

Margin Debt versus NYSE Market Capitalization

Margin debt has grown by over 300% to more than $250 billion since 1993.


THE NUMERATOR

-$100

-$80

-$60

-$40

-$20

$0

$20

$40

12/60 12/63 12/66 12/69 12/72 12/75 12/78 12/81 12/84 12/87 12/90 12/93 12/96 12/99 12/02

Qua

rterly

Cur

rent

Acc

ount

Bal

ance

(in

bill

ions

)

-$106.14 Billion

US Quarterly Current Account Deficit

The US economy and its capital markets are increasingly reliant on the kindness of strangers.

The Current Account Deficit is at record levels.

-$20

$0

$20

$40

$60

$80

$100

$120

$140

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

NET FOREIGN INVESTMENT

Bill

ions

SOURCE: FEDERAL RESERVE BANK

Net Foreign Investment in US Equities

Foreign ownership of US financial assets is also at record levels.


THE DENOMINATOR

Conversely, gold is extraordinarily cheap.

New mine supply has peaked and will decline for the next few years irrespective of gold prices.

Annual Gold Mine Production

500

1000

1500

2000

2500

3000

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Tonn

es

GOLD MINE PRODUCTION

SOURCE: WORLD GOLD COUNCIL

D E L E T E

0.50

1.00

1.50

2.00

$100

$200

$300

$400

$500

$600

$700

$800

$900

12/55 12/58 12/61 12/64 12/67 12/70 12/73 12/76 12/79 12/82 12/85 12/88 12/91 12/94 12/97 12/00

Valu

atio

n Ra

tio (G

VI) D

ollars Per Ounce

GOLD VALUATION INDEX* (left)

PRICE OF GOLD (right)

* SOURCE: CITADEL RESEARCH & ANALYTICS

Gold Undervalued

Gold Overvalued

Gold Valuation Index versus Gold Price

This chart compares the Gold Valuation Model (GVM; left scale) with the actual price of gold (right scale) since 1971. The GVM is derived by dividing the Federal Reserve’s Adjusted Monetary Base by the price of gold bullion. The model indicates that gold is as cheap today, relative to the Monetary Base, as in 1971.


THE DENOMINATOR

And yet, while precise estimates vary, it is generally accepted that annual bullion demand substantially exceeds supply.

Tonnes (a)

DEMAND (b) 4,500

SUPPLY

Mine 2,500

Scrap 600

Total 3,100

SHORTFALL (1,400)

Notes

(a) One "tonne" is a metric ton containing approximately 32,150 oz. (b)

Gold Supply/ Demand - 1999

Estimated total global demand for jewelry, bar, coin & other


THE DENOMINATOR“Official Sector” activity makes up much of the difference between annual demand and new mine production. This consists of outright sales of monetary gold reserves as well as “leasing” of physical gold by central banks. Gold leasing is basically gold banking in a new guise, and results in adding new supply to the physical market while at the same time creating a short physical position typically hedged with paper gold derivatives such as forward contracts, futures or options.

Anatomy of a Short Sale

32

Spot Market

1 Gold Mine

Central Bank Bullion Bank

Speculator

In a typical lease transaction, a central bank deposits gold with a bullion bank on a demand or other short term basis at the current “lease rate” (1). The bullion bank in turn lends the gold to a gold mine or a speculator such as a hedge fund (2), generally at a longer maturity and higher lease rate. In each case the leased gold is sold short (3) and the proceeds are expended or reinvested in financial assets. The central bank now holds the bullion bank’s promise to return its gold. Similarly, the bullion bank now holds its customer’s promise to deliver gold in the future. Both sets of promises are typically hedged through the use of derivatives. In the case of the gold mine, future delivery is presumed to be possible out of future production. In the case of the speculator, future delivery must be purchased in the spot market. In practice, most leases and related gold loans are rolled over, so the cumulative balance continues to increase. The gold, meanwhile, likely finds its way to India.


THE DENOMINATOR

The cumulative exposures created as a result of leasing and related derivatives activity are substantial in relation to the world’s total supply of physical gold.

US $Tonnes (Billions) (a)

Total Above Ground Supply of Physical Gold 125,000 1,105

Total Physical Gold Nominally Held by All Central Banks 33,500 296

Total Physical Gold Nominally Held by Central Bank Signatories & Other Observers of Washington Agreement 28,500 252

Total Notional Amount of Gold Derivatives on Books of G-10 Banks, December 1999 (Source: BIS) 27,485 243

Total Notional Amount of Gold Derivatives on Books of Chase/JP Morgan, December 1999 (Source: OCC) 7,352 65

Total Physical Short Position (high estimate) > 10,000 (b) 88

Total Physical Short Position (low estimate) 5,000 (c) 44

Notes

(a) Conversions between tonnes and US $ expressed at $275/ ounce.(b) Veneroso Associates. (c) Gold Fields Minerals Services Ltd.

The Gold Derivatives Market: Fun Facts


THE DENOMINATOR

The cumulative effect of this activity has been devastating to the gold market and the shares of gold producers. In effect, “Everybody’s out,” and many are short.

At under $40 billion, the market capitalization of the entire gold sector is a fraction of that of GE, Cisco or Microsoft as of September 30, 2000. Meanwhile, aggregate holdings of gold shares by mutual funds have declined to de minimis levels.

$100

$200

$300

$400

$500

$600 $564

$395

$287

$30 $4

Bill

ions

GE CISCO MICROSOFT 31 LARGEST GOLD STOCKS

MUTUAL FUND GOLD STOCK

HOLDINGS


THE DENOMINATOR

A steady drumbeat of negative news and commentary captures the pessimism in the gold market:

“Precious Metals Funds Sinking” - Associated Press, November 26, 2000

“Gold Production from Yukon’s Placer Mines Hits 21-Year-Low”- Associated Press, November 20, 2000

“Gold No Longer Glitters for Investors” - Chicago Daily Herald, November 15, 2000

“In the Golden Sunset / Is gold the dog that barked and may even be dead?”- Financial Times, October 6, 2000

“Gold’s Slide Triggers Exit by Long-Patient Investors: Spotlight”- Bloomberg, October 5, 2000

“Homestake Announces Closure of the Homestake Mine; Expects Further Reductions in Overall Cash Costs” - Homestake Press Release, September 11, 2000


THE DENOMINATOR

The first stirrings of change are evident. Liquidity to support further leasing/derivative activity will be severely restricted going forward. The text of the Washington Agreement, September 26, 1999:

Oesterreichische Nationalbank Banque Nationale de Belgique Suomen PankkiBanca d’Italia Banque centrale du Luxembourg De Nederlandsche BankBanque de France Deutsche Bundesbank Central Bank of IrelandBanco do Portugal Banco de España Sveriges RiksbankSchweizerische Nationalbank Bank of England European Central Bank

In the interest of clarifying their intentions with respect to their gold holdings, the above institutions make the following statement:

1. Gold will remain an important element of global monetary reserves.

2. The above institutions will not enter the market as sellers, with the exception of already decided sales.

3. The gold sales already decided will be achieved through a concerted programme of sales over the next five years. Annual sales will not exceed approximately 400 tonnes and total sales over this period will not exceed 2,000 tonnes.

4. The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.

5. This agreement will be reviewed after five years.


INTERNATIONAL MONETARY CONTEXT

The factors which inform the Dow/Gold Ratio do not operate in domestic isolation, but are instead a function of global monetary conditions.

Each peak in the Dow/Gold Ratio corresponds to a backdrop of excess global credit and liquidity arising from progressive loosenings of constraints in the international monetary system.

• The post-World War I boom of the 1920’s occurred in the context of the gold exchange standard, which permitted a much larger expansion of credit than would have been possible under the classical gold standard in place prior to the Great War.

• The post-World War II boom of the mid-1950’s to the mid-1960’s occurred in the context of the US dollar-based gold exchange rate system of Bretton Woods, which allowed a similar unprecedented expansion.

• The post-Cold War bubble of the 1990’s occurred in the context of the US dollar-based floating exchange rate system, which has permitted the greatest explosion in international credit and liquidity in history.



Neither the gold exchange standard nor the Bretton Woods system produced permanent prosperity. Rather, they resulted only in larger and more destructive economic cycles: two great global booms ending in the worst economic decades of the 20th century: the 1930's and the 1970's. Each peak marks the beginning of a swift descent into near complete international monetary breakdown, from 1929 to 1934 in the first cycle and from 1966 to 1971 in the second, although gold did not reach its peak price until 1980.

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

1915 1925 1935 1945 1955 1965 1975 1985 1995 2005

DJI

A/G

old

Ratio

GOLD EXCHANGE STANDARD (1918-1934)

BRETTON WOODS AGREEMENT (1945-1971)

FLOATING EXCHANGE RATE

(1971-Present)

The Dow/Gold Ratio and Global Monetary Regimes (1915-2000)



In both prior cycles, gold prices were held at unrealistically low levels during the peak years to hide inflation and make governments look good. In each case, much higher gold prices were subsequently a necessary part of the adjustment process. By the end of the last cycle, gold prices were so low relative to mining costs that much of the gold mining industry had closed down amidst a level of devastation not since approached until today.

Gold Market Interventions (1915-2000)

1935 1945 1955 1965 1975 1985 19951915 1925

$20

$30

$40$50

$100

$200

$300

$400$500$600$700

FED LOWERS RATES TO FIGHT BRITISH

GOLD LOSSES (1927-1929)

LONDON GOLD POOL

(1961-1968)

EXPLOSION OF GOLD DERIVATIVES

(1995-Present)

PRICE OF GOLD

Dol

lars

Per

Oun

ce

(Log

Sca

le)


INTERNATIONAL MONETARY CONTEXTThe signs of impending monetary breakdown include increasing direct interventions in commodity and currency markets, bouts of extreme volatility in stocks, currencies and gold, and the emergence of the US Dollar as the dominant official reserve asset.

Foreign Currency Volatility

5%

10%

15%

20%

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000

Annu

aliz

ed V

olat

ility

SWISS FRANC

GERMAN D-MARK

BRITISH POUND HEDGE FUNDS ATTACK

BRITISH POUND

With no anchor to windward, currencies have blown hither and yon since the collapse of BrettonWoods.

Gold and US Dollar Reserves of Foreign Central Banks

$200

$400

$600

$800

$1000

$1200

1950 1960 1970 1980 1990 2000

U.S. CLOSES GOLD WINDOW

Bill

ions

SOURCE: IMF

PAPER RESERVES: Reserves in Central Banks, Plus Reserves at IMF, Plus SDR’s and Foreign Currencies (Almost Exclusively U.S. Dollars)

METAL RESERVES: Gold at Constant Price of $35/oz. In 50 Years, Physical Reserves have Increased Only 12.3%

The buildup of US Dollar reserves corresponds to the decline in gold reserves among central banks.


PROJECTION

Our message is really pretty simple. The broad investment and financial picture in late 2000 parallels quite closely the previous super bull market tops of 1929 and 1966. All our analytic studies show, and all our anecdotal evidence supports, the proposition that the world is on the cusp of a similarly huge investment inflection point today. We don't claim clairvoyance. We cannot yet tell precisely when or how quickly the Dow/Gold ratio will collapse to more normal levels. But we are convinced that it will, and that five years from now a Dow/Gold ratio chart is quite likely to look something like this:

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

1915 1925 1935 1945 1955 1965 1975 1985 1995 2005

Dow

/Gol

d Ra

tio

Dow/Gold Ratio: 1915 - 2005

Documents

THE DOW/GOLD RATIO PDF/Dow Gold Ratio.pdf · chart of the Dow/Gold ratio, which is simply the quotient of the Dow Jones Industrial Average divided by the gold price in US Dollars