Reverting to the Golden Mean
16 March 2009
Sean Russo
AFTER years of attending various gold and base metals conferences and Diggers and Dealers I attended my first oil and gas conference last week. There were a few familiar faces in the crowd that had made the switch from mining, but otherwise it was a new crowd to me.
In several of his presentations at Diggers and Dealers Pierre Lassonde has spoken about the importance of the Dow/Gold Ratio in his strategic thinking about gold. In particular, in the early 2000s when he acquired Normandy and bought back their in-the-money hedge book he was very bullish gold because the ratio was at an all time record high of 40:1.
So what is the Dow/Gold Ratio? The Dow Jones Industrial Average (DJIA) is made up of 30 stocks and the number we see each day, eg Dow 7170 (at the time of writing), is the price weighted average of those 30 share prices. Simply, it would cost $7170 to buy one unit of the DJIA. At any time therefore we can measure the effective exchange rate of gold to US equities by looking at how many ounces one would need to sell to buy the index or vice versa. With gold currently trading at $US925/oz the conversion rate is 7.75 ounces: 1 DJIA.
In the 1980s both the DJIA and gold were trading briefly in the 800s. That’s right, as we entered the eighties it only took the proceeds from the sale of one ounce of gold to buy one each of all 30 stocks in the DJIA. Only 20 years later the sale of the stocks in the same index could fund the purchase of 40oz of gold.
Having a very quick look backwards to assure you this volatility is not new, the brief touch of 1:1 in 1980 was the end of a fall from a high of 30:1 in the early 60s, which itself was the end of a rally from 2:1 in the early 30s. Prior to that, it had been nearly 20:1 in 1929 which was the end of a three decade climb from 1:1 at the start of the last century!
Turning to the graph below you can see the journey of the gold to stocks exchange rate since 1980. Figure X is the DJIA/Gold ratio. It’s not hard to see why Pierre Lassonde thought gold was cheap in 2000, particularly if you consider the weight of history that was behind him.
Ratios for Japanese and Australian investors looking at their local equity benchmark and gold priced in the local currency unit (100:1 for All Ords/AUD gold is equivalent to 1:1 because the unit value of the All Ords is 100 times that of the DJIA) clearly and not surprisingly display some similarities in trend. There are however some very distinct periods of divergence at the higher levels as individual domestic equity bull cycles or currency impacts have dominated – for eg (Japan 87-89), (Australia 2004-2008). I have not seen other commentators look at these other ratios and for purely a gold view they are probably unnecessary. However, I do believe they might be quite instructive for equity investors trying to determine when their particular equity market has reached a solid floor.
I would also suggest that while disparate tops may have allowed USD gold to beat out a wider base as gold’s value was recognised at different times in different markets around the world, our concern should be that if we get down to 1980 levels in stocks/gold ratios in multiple markets at the same time, the selling pressure on gold could be extreme as everyone rushes out of gold and back to stocks at the same time.
Relative values
Having dinner in a pub in Kalgoorlie in 2003 after a rousing bullish cry from Mr Lassonde (where he talked about 1:1 but didn’t offer a gold price fix), I asked a group of miners for their predictions for gold if DJIA/Gold were at 1:1. The consensus was $US5000/oz or thereabouts. When challenged not one believed in their gold price prediction being obtainable but the consensus was that the DJIA really couldn’t go any lower than that. Remember at that time gold was $US375/oz and the DJIA was 9400 for a ratio of 25:1. When it came down to it, they loved Mr Lassonde’s bullish gold stance but they didn’t believe we would ever see DJIA/Gold 1:1 again, it was simply considered implausible because of their bias to ever rising equity prices.
The thing about ratios or exchange rates is there are two legs and sometimes people get them right for all the wrong reasons (or right for all the wrong reasons). Being wildly bullish gold in the belief gold will go racing up to match the DJIA at 1:1 may not be the best way to profit from that view.
An observation
I think we will see the various stock/gold ratios trade to 1980 levels in the next few years. Perhaps we will have a 1980s style spike in gold to achieve it, perhaps global equities will totally collapse; both are possible. If it happens, I believe it will be a sharp down spike in the ratio as it has been in the past. Equities, brought back to the golden mean, will again present incredible long term value. And then, humans being humans, we will again set off on an expansionary run to who knows where.
What I think it means is the undercurrents that have driven the strategy of most big gold miners since 2000, to have no hedging and to issue more shares every time the gold price goes up, are coming to an end. These gold prices and any higher gold prices we see in the next year or so should be used by producers to launch the foundations of sustainable and profitable businesses by looking at ways to secure revenue and support sensible gearing. The producers who prospered and grew in the 80s and 90s as the DJIA/gold rallied from 1 to 40 were the companies that hedged, made profits and kept their registers tight (relatively). Those times are more likely to return and last longer than this current phase.
Major gold producers, remember, you created and supported the gold ETFs to create demand for your product. Your hedge buybacks drove the price higher, building confidence for their longs. They love the safe haven your product currently offers but they don’t love you and they will leave you (and sell your product) as soon as they can buy shares, at bargain basement prices, in companies that see their job as making profits, year in year out, not simply offering raw gold price exposure. That time is fast approaching.