Dow-Gold Ratio.

The Dow-Gold ratio represents the most important ratio between the relative prices of financial assets and real assets.

The Dow component represents the valuation of financial assets; the gold component – of real assets.

When leverage in the financial system increases significantly, so does this ratio. A very high ratio is interpreted as an imbalance between financial and real assets – financial assets are grossly overvalued, while real assets are grossly undervalued.

It also implies that a correction eventually will be necessary – either through deflation, which implies deleveraging and a collapsing stock market, or through inflation, which implies stagnant stock market for many years and steadily rising prices of real assets, commodities, and gold, usually associated with stagnant economy and typically resulting in stagflation. The first case—deflation—occurred during the 1930s, while the second case—stagflation—occurred during the 1970s

The graph above illustrates the above concepts. The very high Dow-Gold Ratio in 1929 was followed by the Great Depression, while the higher level in 1966 was followed by the stagflationary 70s.

It is evident from the chart the peak in 2000 surpassed the previous two peaks in 1929 and 1966, so this provides a reasonable expectation that the forthcoming return to “normalcy” will be more painful than the Great Depression, at least in terms of cumulative pain over the next 10-15 years.

The first scenario , deflation, implies a major contraction in the supply of money and credit, similar to the one during the Great Depression. Consumer and commodity prices would fall rapidly; the stock market and real estate market would collapse. Back then, stock prices and real estate fell roughly 10 times and gold rose only a little. If this scenario were to play out, then a reasonable forecast for the Dow will be about $1,000-1,500, while the gold price will be likely in the range of $800-1,500. This scenario is highly unlikely as the Fed will fight tooth and nail to prevent a deflation from taking hold.

The second scenario , stagflation, is most likely. It should look similar to the 1970s. Back then, the Dow made its peak in 1966. It made little progress for about 15 years, so that in 1980 it was just about where it was in 1966, roughly around 1,000. Gold, on the other hand, rose from a low of $35 all the way to $850. This means that strong inflation during the period kept the Dow from falling, so it did not fall as it did during the Great Depression. On the other hand, inflation powered the price of gold about 25-fold. In this scenario, we should expect the Dow to remain range-bound in the 10,000-15,000 range. Then, a gold forecast of 10,000 is perfectly realistic.

The third scenario , very strong inflation, is definitely possible, although less likely than stagflation. This would mean a typical, commonly-observed inflation of a third-world country, may be 15-25% annually. This kind of inflation could easily power the Dow may be 3-4 times in the coming decade, may be all the way to $30,000-50,000. This could mean a $20 for a loaf of bread or a gallon of gasoline. This would imply a gold price in the range of 20,000-50,000. It is possible, even probable, but in my opinion, not very realistic.