The All Ords/Gold Ratio

A couple of posts back I detailed the relationship between the Dow Jones Industrial Average and gold. Historically, exchanging gold for stocks when the valuation has been less than five then exchanging stock for gold at a later point has been a highly profitable strategy. In this post, I want to explore whether a similar relationship exists for gold and the All Ordinaries Index.

The Australian dollar has a long history as a 'gold dollar'. Australia is among the top gold producers in the world, along with South Africa and the US. More recently, China has grown into a significant producer. However, in terms of the value of gold as a proportion of the overall economy, gold production is much more important for Australia (and South Africa) than it is in China or the US (a $10 billion gold mining industry in a nation with a population of 20 million is going to be 15 times more economically important than a $10 billion gold mining industry in a country with 300 million people).

This reliance on gold means a couple of things. When the value of gold goes up, it will create demand for Australian dollars both due to investment in mining, and to purchase the gold produced from our mines. Second, when the value of gold declines, the Australian dollar goes down as there is less demand for dollars to invest, and less dollars are needed to buy the same amount of gold. The net result (in theory) is that the price of gold denominated in Australian dollars is less volatile than gold denominated in other currencies. For example, if gold costs US$500 an ounce one Australian dollar buys 50 US cents, gold will be worth AU$1000. If the price of gold increases to US$700, this will increase demand for Australian dollars, and one Australian dollar may now buy 60 US cents, so gold will be worth $1166 an ounce. In US dollar terms, gold has gone up by 40%, while in Australian dollars it has risen only 17%. Similarly, if gold falls from US$700 to $500, demand for Australian dollars falls and may now only buy 50 US cents once again. In US dollar terms, the price of gold has fallen 28%, while in Australian dollar terms it has fallen only 14%.

That theory, with some exceptions, generally does hold true. Generally a weak Australian dollar equals a weak gold price, and vice versa. The moderating affect of the currency on gold price should also, naturally, extend to the relationship between stock markets and gold price. The All Ords:Gold ratio should be much less volatile than the Dow:Gold ratio because the price of gold itself is less volatile in Australia than in the United States.

Now for the chart:


The red line in the chart represents the Dow:gold ratio that I detailed in an earlier post. The blue line represents the All Ords:gold ratio. As predicted above, the All Ords is much less volatile than the Dow. Despite having near equal values in the early 1930s, the Dow:gold ratio peaked at 27 in the 60s, while the All Ords:gold managed just 13. Similarly, the two ratios had near equal values in the early 1980s; while the Dow:gold went on to went a peak of nearly 40, the All Ords:gold managed less than 7.

The moderating affect of such an important gold industry may play a role in this, but I dont think it gives us the whole picture. There are some other factors at play that may explain the differences. The first is fiscal policy. The US authorities are generally more eager to flood markets with cheap credit than in Australia. More excess money equals bigger bubbles, and, inevitably, bigger bubble bursts. The second factor relates specifically to the 1999 bubble. This was the 'tech bubble'. Im sure most of you can remember the short-lived craze of paying incredible prices for stocks like Amazon in the belief that they may one day make some money. The assets became massively overvalued, and eventually the bubble burst. Australia did not have a tech bubble: we lacked the communications infrastructure at the time to really develop one. I can recall paying $8 an hour for a 14.4k dialup connection in the late 90s - hardly the bleeding edge of a brave new technological world even back then. In hindsight, we dodged a bullet.

So what does this mean for investing? A couple of things. First, if you want to chase stock:gold bubbles, you are better off looking to the United States than Australia. If you are intent on applying this to the Australian market, buying at a All Ords:gold ratio of 2.5 and selling somewhere around 6 would have been a fairly successful way of going about it. You might be able to get in lower than that working on daily data (remember that the data in the charts is only end of year data) I eyeballed a some daily gold and all ords prices a while back and it seems to get down to about 2.2 earlier this year.

One important thing to remember about all this is that it is all about exchanging one class of assets for another when one is cheap relative to the other. It doesnt necessarily correlate with the highest values of either asset in dollar terms. For example, in the chart above, the All Ords:gold most recently peaked in 1999, when the All Ords was around 3100. The All Ords didnt reach its dollar peak until 2007, at around 6700. However, in between the gold price had risen, and risen faster than the All Ordinaries. So if you had of exchanged stocks for gold in 1999, you would have bought more gold than if you had done the same in 2007, despite the All Ords more than doubling in dollar terms. If you can exchange one class of assets for another at an optimum time, and both these assets appreciate in the long term, you are going to end up a lot better off than if you merely held one or both of these assets all the time.

Bretton-Woods

Just a quick additional to my last post. In my last post I described how some of the valuation differences between the two assets were the result of stock market bubbles, and alluded valuation differences arising from currency manipulation.

If you want to understand what happened during the 'currency manipulation bubble', I suggest reading the preface to this piece by Murray Rothbard, where he explains the mechanics and failure of the Breton-Woods system. I havent had a chance to read the entire piece yet, but Murray makes a very bold and chilling prediction:

"the financial press is filled with stories that the FDIC might well become bankrupt without a further infusion of taxpayer funds. Whereas the “safe” level of FDIC reserves to the deposits it “insures” is alleged to be 1.5 percent, the ratio is now sinking to approximately 0.2 percent, and this is held to be cause for concern.

The important point here is a basic change that has occurred in the psychology of the market and of the public. In contrast to the naive and unquestioning faith of yesteryear, everyone now realizes at least the possibility of collapse of the FDIC. At some point in the possibly near future, perhaps in the next recession and the next spate of bad bank loans, it might dawn upon the public that 1.5 percent is not very safe either, and that no such level can guard against the irresistible holocaust of the bank run. At that point, ignoring the usual mendacious assurances and soothing-syrup of the Establishment, the commercial banks might be plunged into their ultimate crisis. The United States authorities would then be faced with two stark choices. One would be to allow the entire banking system to collapse, along with virtually all the deposits and depositors in that system. Since, given the mind-set of American politicians, and their evident philosophy of “too big to fail,” it is certain that they would be forced to embrace the second alternative: massive, hyper-inflationary printing of enough cash to pay off all the bank liabilities. The redeposit of such cash in the banking system would bring about an immediate runaway inflation and a massive flight from the dollar."

Now bear in mind that this was written in 1991. We have seen a crisis in the banking sector bought about by exactly the bad loans Murray describes. We have seen the failure of government-backed insurers to deal with this. We have seen a massive government intervention to stave off the problem, paid for by printing new money, trillions of dollars. We are yet to see the hyperinflation and flight from the dollar, but I believe that it is coming.

The DOW/Gold Ratio

A popular long-term analysis in the United States is examining the relationship between gold and the Dow Jones Industrial Average. There is a lot of information out there on if you google Dow/Gold ratio, so I wont go into it in too much detail (I could talk for days on this). Below is a chart of the relationship since 1896:


In 1915 it would buy one ‘Dow’, you would need about five ounces of gold (Dow=99, Gold=$20.67). In 1928, you would need 14 ounces of gold to buy one Dow (Dow=300, Gold=$20.67). In 1999, you’d need about 40 ounces of gold to buy one Dow (Dow=11500, Gold=$290). From the chart, it is clear that there are times when gold is cheap relative to the Dow, and other times when the Dow is cheap relative to gold.

In broad terms, the Dow:Gold ratio is most often somewhere around five. This was the case from 1986-1925, and again from 1931-1951. Occasionally, the Dow becomes much more valuable relative to gold, and then returns to five or less. Im not going to go all the way into the reasons for this, it isn’t vital right now. Suffice to say that I believe that it is due to central banks and governments manipulating the currency and creating excessive credit, giving us the ‘bubble’ cycle.

The first great break above a ratio of 5 is in the 1920’s. This was the bubble that gave us the great depression. The next break, and by far the longest lasting, occurred in the aftermath of WW2. Here the US government and the Federal Reserve simply printed too much paper money. At the time, the gold price was regulated at $35 an ounce (and for every $35 in circulation there was meant to be an ounce of gold in Fort Knox, which makes printing money out of thin air fraud on a massive scale!!!). As more money came into circulation, this inflated prices, including stock prices. Given that gold could not move in line with this inflation, the Dow/Gold ratio rose dramatically.

In the 1970s, the US government finally conceded that the relationship between gold and the US dollar couldn’t be sustained, the debasement of the currency was too complete to restore the currency. Gold became a regular commodity like any other, worth whatever anyone was willing to pay for it. Given that the price of gold had been held artificially low for such a long time, the price of gold soared, and the Dow/gold ratio collapsed.

The final peak we see is the tech bubble and its aftermath. The market became obsessed with the ‘new economy’ of the internet, and shunned gold, the barbarous relic. After the bubble burst in 1999, the ratio fell sharply and continues to fall. If history follows its usual trend, we have a way to go yet. The Dow/Gold ratio should go to five or below. Some are predicting it will be much, much lower than five. I believe that in the next decade or so the US will suffer a ‘dollar crisis’, where the international community loses faith altogether in the dollar and replaces it. If this happens, the US will collapse, and who knows how low the Dow/Gold ratio will go?

So much for history. From the Dow/Gold ratio we can learn a few things. First, it can be used to identify whether the US market is currently in a stock bubble. Second, it gives a measure of the cheapness/expense of gold independent of nominal dollar prices. Third, it provides generational opportunities to buy/sell gold and stocks. If you had sold gold and bought stocks when the Dow/Gold was three and exchanged stocks for gold sold them at even 15, you would be a very well off (if ancient) person by now. Judging by the chart, we are approaching the next generational opportunity to buy US stocks. In a few years to a decade, those holding gold will have an opportunity US stocks at once-in-a-generation prices. Pay attention, you’ll probably be quite old by the time you next stocks this cheap relative to gold.

It may well sound good (or horrific depending on your perspective) for the Americans, but what does it mean for us here in Australia? A few things, which I will explain in my next post.

Reminder Link

This blog has been running for a while now, and the posts that describe the trading systems/ideas that are described here have fallen into the archives.

Here is a link to those posts:

All Ordinaries, Economic Growth and Inflation

AUD/JPY: A systematic relationship

and, of course,

Welcome and Disclaimer

End of July update

Another two months have gone by (and didnt they fly!), so time for another update.

Over the last couple of months the market has staged a fairly strong recovery, and emerged fairly strongly from the -20% buy zone. We finished July at -14.5% from the market fair value. The market is still undervalued, but following the system that I outlined, we are now in a neutral hold zone. Chart below:

So where do we go from here? Long term, the market will grow in line with the economy. During that, there will be periodic swings of exuberance and pessimism that we can use to our advantage. More immediately, looking at the last thirty years of data in the chart above, once the market has climbed back above -20%, it has risen fairly dramatically, usually approaching the fair value within a couple of years. Whether this happens this time or we see a reversion to -20% or below remains to be seen. What is important to remember is that over the long term, we will see growth, the market will return to its fair value, and parts beyond.

Something to ponder: In November 2008 we first finished the month in the buy zone. Using the buying strategy outlined earlier, you would buy when the market finishes the month at or below -20%. In this instance you would have bought at 3389. At the end of July 2009, the market closed at 4250, a gain of about 25% plus dividends. Not bad money in my opinion.

End of May, 2009

A couple more months have just fallen away, and it seems that a lot of market pessimism has gone with it. Obviously, this has all happened because I mentioned that things may stay subdued for some time last update.

All said and done, we havent recovered yet, and the market may go down again. We closed the month of May with the All Ords at 3888. This just nudges us out of the -20% 'buy zone', to -19.21%, which is the -20% - 50% 'hold zone'.

A word of caution though: while the historical data that I used to build this system is accurate, forward-looking predictions are just that, predictions. They are based on assumptions of economic growth and inflation that may change. Changes wont make much difference to the system, for example, 1% economic growth either way only moves the -20% line by 30-something points. The reason that Im telling you this is that there is a little ambiguity here, so if you want to buy at 3888 instead of 3777, it wont make much difference at the end of the day.

In other news, the carry trade strategy is kicking butt. The Australian dollar has appreciated rapidly, and the AUD/JPY is currently a whopping 78.5. This equates to a 131% gain since I bought Australian dollars for 59.3 at the start of this year. It seems to have run up a bit too quickly, so we'll probably see a retracement before long.

No charts this update, but if you are following this, you should know what Im talking about by now!

End of March update

Its been a fairly subdued couple of months in the market. There appears to be early signs of a recovery, which is what would be expected after the All Ords drops below -20%. However, at the end of March this is the fifth month below -20%.

As you can see from the chart, in most instances when the market reaches -20% it rebounds quite rapidly, within a couple of months the market turns around and is back above the -20% buy zone. This is different. It is starting to resemble the 1981-1983 period, where the market stayed below -20% for 18 consequtive months, and plumbed much lower depths (lower than -30%) than usual.

Im sure that some out there are wondering whether the market will ever recover. We've certainly heard enough commentary about the 'end of capitalism' over the last year. People were thinking the same things in the early 1980s. But the market did recover in the 1980s, and it will undoubtedly do it again. We can now look back at the early 1980s as the great buying opportunity that it was. I believe that we find ourselves in much the same situation today.

AUD/JPY carry trading has firmly emerged from the sub-60 buy zone, currently sitting around 71. I now think that its unlikely that we will return to the buy zone any time soon, but be ready just in case. At the moment, my carry trading account is up 100%. Approximately 94% of this is unrealised capital gains, and the remainer balance and position interest.


In other news, Im hoping to get some more analysis up this month. I've applied my All Ords analysis to the Dow Jones. This has not been at all successful, which I think is due to the official US growth and inflation figures being an utter work of fiction. I may publish this anyway, just for interest. I'm also hoping to repeat the analysis with the FTSE and the Nikkei, so hopefully at least one of these will be up this month.