Monday, February 15, 2010

A Tale of Two Cities (part 2)


Here's the bad news for equities. This graph (click to enlarge) charts the DJIA relative to the price of 1 ounce of gold. At the height of the internet bubble, the DJIA/gold ratio was 44--and clearly unsustainable. At the depths of previous bear markets, the ratio was unity (1:1).

Currently, the ratio is around 10:1, and trending downward in the short- and mid-term. In order for the ratio to reach unity, the Dow Jones index has to either decline by a significant amount, or the price of gold per ounce has to increase by a significant amount--or both have to occur simultaneously. Simply put, the numerator (DJIA) has to match the denominator (gold price per ounce).

The take away message from the disaggregation of both charts is that while financial asset values may increase appreciably in nominal terms, in real terms (i.e. inflation-adjusted or indexed against gold), the returns for equities do not appreciate nearly as much when measured over a long period of time. In other words, the rate of return for equities is impaired due to the devaluation of the USDollar.

No one has a crystal ball, but the short US equities / long gold trade seems like the logical play going forward. Of course, with governments and central bankers wreaking havoc by manipulating markets worldwide, logic doesn't always win out initially. Fundamentals become distorted beyond recognition as bubbles are created and burst, causing investors to lose money, despite making correct market calls. Timing becomes the enemy, not the ally. So tread carefully. Read the disclaimers in the sidebar. Perform your own due diligence.

Disclosure: long biotech and energy sector equities, long gold and silver mining shares.

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